Sunday, August 10, 2008

Fx: Is carry doomed?

The DailyFX Volatility Index is a composite of the implied volatility in options underlying an equally weighed basket of currencies and measures the general level of volatility in the currency market. A rising index (as seen in the lower left chart) suggest increased option premium buying and generally more active currency markets. It is also unfavorable for carry trades which underperform during high volatility. In recent weeks economic data suggest a marked slowdown in the global economy. Differentials in benchmark lending rates between the U.S. dollar and other currencies (Euro, GBP and Yen) have narrowed indicating diminished expectations for rate increases outside the U.S. The lower right graph shows reduced expectations for the Bank of Japan to raise interest rates over the coming 12 months. The yen is the main funding currency for carry trades. Not surprisingly the DailyFx Carry Trade Index has broken down.

From DailyFx:
While all eyes were on the US dollar’s major breakout effort towards the end of this past week, a look away from the majors revealed another major currency market trend change: the breakdown in the carry trade. By Friday’s close, the DailyFX Carry Trade Index closed at 27,954 after a 571 plunge from last week which brought the basket to its lowest level since April 14th. This sharp reversal officially curbed any speculation that demand for interest rate differentials could push to new highs while risk appetite faded and the potential for returns faded. Not surprisingly, the supplementary data we monitor has deteriorated along with the drop in carry. Action in the currency market drove the DailyFX Volatility Index back above the closely watched 10 percent level. At the same time risk reversals have still favored calls and seemingly beneficial USDJPY bullishness. However, this is a fundamental anomaly. Aside from the USDJPY’s advance this past week, almost every other carry sensitive pair plummeted (thereby driving the Carry Index down).

click to enlage

In our opinion the breakdown in the carry trade this past week was not a sign of risk reversal but rather of reduced expectations for interest rate differentials between the U.S. dollar and other currencies. As indicated above the dollar managed to break out gains against the yen and equity markets also closed higher on Friday.

source: US Dollar Rally Masks A Severe Carry Breakdown

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