Forex

Interest rate expectations recharged the carry trade this past week; but a significant jump in risk aversion throughout the capital markets curbed the currency strategy. On balance, the shock from the sharp equities sell off yesterday reversed earlier gains in the DailyFX Carry Trade Index leaving the gauge 57 points lower on the week at 28,843. Supporting the air of caution in an otherwise strong carry trend, market condition indicators were reflecting modest improvements from last week. Currency traders were still relatively confident in the outlook yield demand and less concerned over the possibility of panic selling. Risk reversals for USDJPY (the proxy for the carry) rose as calls grew in value; and the DailyFX Volatility Index fell back below 10 percent following last week’s unexpected jump.

• A Sharp Drop In Risk Appetite Cuts A Possible Carry Trade Breakout Short
• Credit Market Conditions Improve While Capital Markets Tumble, Is This A Natural Bear Market?
• Interest Rate Differentials May Not Offset Possible Capital Losses With Risk Rising

Interest rate expectations recharged the carry trade this past week; but a significant jump in risk aversion throughout the capital markets curbed the currency strategy. On balance, the shock from the sharp equities sell off yesterday reversed earlier gains in the DailyFX Carry Trade Index leaving the gauge 57 points lower on the week at 28,843. Supporting the air of caution in an otherwise strong carry trend, market condition indicators were reflecting modest improvements from last week. Currency traders were still relatively confident in the outlook yield demand and less concerned over the possibility of panic selling. Risk reversals for USDJPY (the proxy for the carry) rose as calls grew in value; and the DailyFX Volatility Index fell back below 10 percent following last week’s unexpected jump.

The carry trade is in an interesting position this week. On the one hand, many of the benchmark carry pairs are still near the highs of their respective rallies – and the recent pull back has certainly not threatened the hearty trends. Conversely, the capital markets have undergone a clear reversal in risk sentiment with equity markets tumbling to new lows. In fact, with Thursday’s close, the Dow was at its lowest level since November of last year while European shares plunged to levels not seen since November of 2005. With USD JPY over 1,100 points above its own multi-year low and the Dow just now pressing to fresh lows, it seems that the risk correlation is breaking down. However, this has likely been facilitated by steady improvements in the credit market which leads us to believe the bearish turn in capital market’s is of a ‘natural’ sort and not the panic surrounding investment stability from last summer. Nonetheless, a decline in equity markets generally suggests risk appetite and yield are on the wane – unfavorable conditions for carry. Furthermore, with the Fed and ECB threatening hikes and RBNZ seeing cuts while the RBA holds, the potential for return is fading as risk rises.