Friday, February 18, 2011

Currency Markets, Risk Appetite Threaten Trend-Defining Reversal Next Week

* Currency Markets, Risk Appetite Threaten Trend-Defining Reversal
Next Week

* Will the Economic Docket Claim Responsibility for the Next Trend
or Pure Sentiment?

* European Financial Strains and Chinese Bubble Concerns Starting to
Show Through Equity Climb

The currency market - and perhaps the financial market at large
– is looking at the best opportunity to jump start a meaningful
and enduring trend that we have seen in many months next week. The
vast majority of the time, the markets are set within some form of
trend. This does not necessarily entail a bullish or bearish bias.
Rather, the inclination resides in a sense of familiarity for the
crowd. Whether the masses agree congestion on EURUSD, a persistent
climb for the S&P 500 or tumble for the 10-year US Treasury note
is the appropriate level of activity and direction; it is the
consistency in performance that reinforces the trend and lulls
market participants into a sense of comfort. Yet, it is inevitable
that the speculative arena eventually changes gears. Identifying
these moments ahead of schedule is not simple. A technical
correction for a particularly liquid asset or even a concerted go
across an entire asset class does not necessarily confirm an
underlying shift. That is something we learned with the disastrous
S&P 500 breakdown on last Friday of January and the small-lived
reversal from AUDUSD back in November. A right trend change
develops through an adjustment to essential expectations for risk
and reward rather than a mere shock of volatility. And, these are
the exact elements that we are looking for the pressing future.

We have been looking for evidence of an obvious revival in correlation
across the various asset classes and subsequent drive behind this
freshly together market for some time. Aside from a few brief periods
of gray risk-driven moves; we haven't seen whatever thing this
consistent since the reinvestment effort after the worst of the
financial crisis between March and December of 2009. Leading up to the
ultimate return of conviction, we find complacency and
under-appreciation of risk have become the rule. We see a lack of
concern in the equities-based VIX Index just off three-and-a-half year
lows while junk bond spreads have contracted to levels last seen in
2007. What makes this complacency perilous is the steady advance in
speculative assets. The weigh of expectations for reasonable returns
against the threat of financial shakiness has been heavily skewed such
that the market in general finds itself richly valued. But, investors
can remain ignorant of this threat and continue to plow money into the
markets until something forces the masses to reevaluate the
circumstances. What we need is a catalyst or range of catalysts to
shake confidence.

Taking stock of the danger of a collapse in confidence through the
pressing future, we only need to look at the economic calendar. We
will be reminded of Europe's long recovery time with the release of
the region's first round of 4Q GDP figures. This includes not only
the Euro Zone and Germany figures but the Portuguese and Greek updates
as well. This could easily swamp the inert recovery in confidence the
region has found due to the open-finished and so far shaky promise
policy officials made to expand their bailout efforts. In the UK, the
front-line battle between fiscal simplicity, economic growth and high
inflation will be strained by employment data and the BoE's
Quarterly Inflation Report. Largely overlooked, the US started the
wheels turning on transferring the glut of toxic assets off the
government's weigh sheet back to the blissfully ignorant speculator
by announcing its intensions to wind down Fannie Mae and Freddie Mac.
Then, there is Plates's accelerating effort to tighten the reins on
speculative capital. This gives rise to the potential momentum behind
the inevitable risk aversion go. Global investors won't necessarily
withdrawal funds from the system so much as they will right the
imbalance between developed and emerging market economies and reverse
the steady speculative build up.

DailyFX Involve Trade Index

Risk Indicators:

DailyFX Volatility Index

What is the DailyFX Volatility Index:

The DailyFX Volatility Index measures the general level of volatility
in the currency market. The index is a composite of the implied
volatility in options underlying a basket of currencies. Our basket is
equally weighed and composed of some of the most liquid currency pairs
in the Foreign exchange market.

In reading this graph, whenever the DailyFX Volatility Index rises, it
suggests traders expect the currency market to be more active in the
coming days and weeks. Since involve trades underperform when
volatility is high (due to the threat of capital losses that may
overwhelm involve income), a rise in volatility is unfavorable for the

USDJPY 25 Delta Risk Reversals 3 Month

What are Risk Reversals:Risk reversals are the difference in
volatility between similar (in expiration and relative strike levels)
FX calls and place options. The measurement is calculated by finding
the difference between the implied volatility of a call with a 25
Delta and a place with a 25 Delta. When Risk Reversals are skewed to
the downside, it suggests volatility and therefore demand is superior
for puts than for calls and traders are expecting the pair to fall;
and vice versa.

We use risk reversals on USDJPY as global interest are bottoming after
having fallen substantially over the past year or more. Both the US
and Japanese benchmark lending rates are near zero and expected to
remain there until at least the middle of 2010. This attributes level
of stability to this pairs options that better allows it to follow
investment trends. When Risk Reversals go to a negative extreme, it
typically reflects a demand for safety of funds - an unfavorable
condition for involve.

Reserve Bank of Australia Expectations

How are Rate Expectations calculated:

Forecasting rate decisions is notoriously speculative, yet the market
is typically very efficient at predicting rate movements (and many
economists and analysts even believe market prices influence policy
decisions). To take advantage of the collective wisdom of the market
in forecasting rate decisions, we will use a combination of long and
small-term, risk-free interest rate assets to determine the cumulative
movement the Reserve Bank of Australia (RBA) will make over the coming
12 months. We have select the RBA as the Australian dollar is one of
few currencies, still considered a high yielders.To read this chart,
any positive number represents an expected firming in the Australian
benchmark lending rate over the coming year with each point in place
of one basis point change. When rate expectations rise, the involve
differential is expected to increase and involve trades return

Highest And Lowest Yields:

The Interest rate used to benchmark the currency basket is the 3
months Libor rate

Is Involve Trade and risk appetite rising or diminishing? Discuss how
to trade yields and market sentiment in the DailyFX Forum

Additional Information

What is a Involve Trade

All that is needed to know the involve trade concept is a basic
knowledge of foreign exchange and interest rates differentials. Each
currency has a different interest rate attached to it determined
partly by policy authorities and partly by market demand.When taking a
foreign exchange spot a trader holds long spot one currency and small
spot in another. Each day, the trader will collect the interest on the
long side of their trade and pay the interest on the small side. If
the interest rate on the bought currency is higher than that of the
sold currency, the result is a net inflow of interest. If the sold
currency's interest rate is superior than the bought currency's
rate, the trader must pay the net interest.

Involve Trade As A Strategy

For many years, money managers and banks have utilized the inflow and
outflow of yield to collect consistent income in times of low
volatility and high risk appetite. Holding only one or two currency
pairs would invite considerable idiosyncratic risk (or risk related to
those few pairs held); so traders start portfolios of various involve
trade pairs to diversify risk from any single pair and isolate
exposure to demand for yield. But, even with risk diversified away
from any one pair, a involve basket is still exposed to those
conditions that render this yield seeking strategy undesirable, such
as: high volatility, tiny interest rate differentials or a general
aversion to risk. Therefore, the involve trade will consistently
collect an interest income, but there are still circumstances when the
involve trade can face large drawdowns in certain market conditions.
As such, a trader needs to choose when it is time to underweight or
overweight their involve trade exposure.

Written by: John Kicklighter, Currency Strategist for

To receive John's reports via send by e-mail or to submit Questions
or Comments about an condition; send by e-mail jkicklighter@dailyfx.


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