QE2 Expiring, Greece Crisis Deeping –Perfect Storm for Dollar, Risk

QE2 Expiring, Greece Crisis Deeping –Perfect Storm for Dollar, Risk

By John Kicklighter, Currency Strategist
25 June 2011 05:25 GMT



* QE2 Expiring, Greece Crisis Deeping –Perfect Storm for Dollar, Risk
* Liquidity Demand Swelling as Speculative Returns Falling Back
* S&P 500, Gold, Oil, Treasuries and the Dollar All Position For Reversals

The FX market’s most liquid pair (EURUSD) and carry trade itself are on the verge of significant, bearish reversals. However, that is not the full extent of the tension. If we broaden our scope to include equities, commodities, Treasury and money markets; we see the same general patterns. After long-running rallies and a subsequent period of congestion, all of these prominent asset classes are threatening trend-defining reversals. What makes this particularly interesting though is that they are all lining up to the same fundamental conclusion: the shift of capital from the high-yielding and high-risk assets to the deeply liquid safe havens. And, it just so happens, that a series of fundamental fronts are coming together to threaten the perfect market event to prompt trigger just such a elemental change.

Looking across the markets, we should account for the pressure on the various benchmarks and the fundamental correlation their respective strain reflects. At the forefront are the favored speculative assets. The S&P 500 has broken a bull trend that has guided the index to three-year highs since September. The critical step, though, will come when 1,250 gives way and the advance from the March 2009 ‘V’-shaped reversal following the worst financial crisis in modern history is finally broken. US Oil is facing a similar crossroad around $90-per-barrel. Things are a little more complicated when it comes to the bonds and rates market. The reflection of an active US-government bid, the 10-year Treasury is starting to waver after a multi-month run; while the three-month US Libor rate is slowing its descent to fresh record lows. Marking the absolute foundation of the global financial markets, we are starting to see disturbing rumblings in overnight cash markets. Short-term cash spread have shown significant jumps in US, European and Asian markets. Looking back, the freeze of funds at this level turned a market slump into a full blown crisis back in late 2008.

Developments that have ushered the market to this ledge have been long incubating; but until recently, the collective speculative ranks have been able to downgrade the risks to focus on returns. The unquestionable support of the world’s governments has created an unmistakable brand of moral hazard and exceptionally low lending rates – factors that are so substantial that otherwise anemic rates of return have offset a fundamental risk like a building European financial crisis. The situation with Greece is perhaps the most easily identifiable; but it hardly stops there. We have already seen the funding and ratings troubles hit Portugal, Ireland, Spain and now Italy. Outside of Europe, we have a cash crunch developing in China following its effort to curb excessive lending, the fallout of UK austerity, a Japanese economy that is struggling to balance finances with growth and the US planning to let its stimulus build up expire.

The end of QE2 is perhaps the most important change the global markets face. The US government’s and Fed’s effort to pump capital into its economy and market has indirectly propped up global speculation. Much of the capital that was destined for US businesses and consumers made its way to emerging markets and other countries’ endeavors. When this cheap funding is withdrawn, the leverage for sentiment and yield will be taken away. Moving forward, the Fed will likely hold its balance sheet stable for some months before embarking on a drawdown. That said, speculation of this change and a swell in the risk side of the ledger will put things into motion.




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 carry trades underperform when volatility is high (due to the threat of capital losses that may overwhelm carry income), a rise in volatility is unfavorable for the strategy.

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 put options. The measurement is calculated by finding the difference between the implied volatility of a call with a 25 Delta and a put with a 25 Delta. When Risk Reversals are skewed to the downside, it suggests volatility and therefore demand is greater 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 end of 2011. This attributes level of stability to this pairs options that better allows it to follow investment trends. When Risk Reversals move to a negative extreme, it typically reflects a demand for safety of funds - an unfavorable condition for carry.

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 short-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 chosen 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 representing one basis point change. When rate expectations rise, the carry differential is expected to increase and carry trades return improves.

Highest And Lowest Yields:


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

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

Additional Information

What is a Carry Trade

All that is needed to understand the carry 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 position a trader holds long position one currency and short position in another. Each day, the trader will collect the interest on the long side of their trade and pay the interest on the short side. If the interest rate on the purchased 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 greater than the purchased currency’s rate, the trader must pay the net interest.

Carry 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 create portfolios of various carry trade pairs to diversify risk from any single pair and isolate exposure to demand for yield. However, even with risk diversified away from any one pair, a carry basket is still exposed to those conditions that render this yield seeking strategy undesirable, such as: high volatility, small interest rate differentials or a general aversion to risk. Therefore, the carry trade will consistently collect an interest income, but there are still situation when the carry trade can face large drawdowns in certain market conditions. As such, a trader needs to decide when it is time to underweight or overweight their carry trade exposure.

Written by: John Kicklighter, Senior Currency Strategist for DailyFX.com

To receive John’s reports via email or to submit Questions or Comments about an article; email jkicklighter@dailyfx.



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Greece ‘cannot avert default’


By REUTERS
Published: Jun 25, 2011 22:44


NEW YORK: Greece has no choice but to default on its massive debt, which will crush the euro and the European banking system, said John Taylor, chief executive officer of the $8-billion currency hedge fund FX Concepts.

“I don’t see any solution to the Greek crisis. It is totally, absolutely impossible for this to work out,” he said.

“Greece has got to default and it’s going to mean Ireland, Spain and Portugal are going to have default as an option. And this is going to mess up the euro and the European banking system.”

On Friday, banks and policymakers moved closer to a deal to help Athens secure funds ahead of a parliamentary vote on austerity next week that Greek Prime Minister George Papandreou must win to avert default.

Despite a refusal by the conservative opposition to back the plan along with signs of revolt in his own socialist party, Papandreou said he was confident the deeply unpopular package of spending cuts, tax hikes and privatizations would pass.
“It is a moment of historic importance. If everybody resists, worse things will come, perhaps even bankruptcy,” Papandreou told a news conference at the sidelines of a summit of European Union leaders in Brussels.

FX Concepts’ Taylor, who predicted late last year that the US could enter another recession in 2011, repeated his forecast that the euro will slide to parity against the US dollar, although he’s not certain of the timing.

On Friday, the euro was down 0.6 percent at $1.41700, but still up 5.9 percent so far this year.

In October last year, he said the euro would most likely peak between $1.43-$1.45 in November and was most negative on the euro versus the dollar at a time when almost everybody was selling the greenback because of the Federal Reserve’s quantitative easing.

Taylor does not think the austerity measures will pass. Even if the Greek parliament does approve the plan, the government will be tested once again by a referendum this autumn on Greek electoral and political changes. This could evolve into a de facto test of support for the government and its austerity program.
“The track that the euro is on assures that the voters, or the mobs...will push their governments into leaving the euro or completely changing it.”

Taylor said the European Central Bank is making a mistake by raising interest rates at a time when 15 countries out of the 17 in the euro zone are in recession.
“The ECB is playing it too close to the Germans. They’re really just worried about Germany overheating. Screw the Germans! Let the Germans do the internal things to slow their own economy.”

“I know their office is in Frankfurt and I know that they’re fashioning themselves as the modern Bundesbank. But the ECB is crucifying 15 countries, which are in recession, and (catering) to the two (countries) which are not in recession.”
Taylor said the euro zone crisis overshadows all other global worries and could plunge major economies into another recession.

“It looks like h*ll to me. This should be the beginning of a major decline in risk assets,” Taylor said.

In December last year, Taylor said the US economy is headed for a recession this year that is likely to benefit the dollar, weigh on the market and commodity prices.
The recent soft patch of economic data has increased speculation over whether US policymakers will engineer a third round of bond purchases, an unconventional monetary measure known as “quantitative easing.” The $600 billion that makes up a second round, or QE2, will conclude on June 30.

So far this month, the S&P 500 is down 5.5 percent on pace for its worst monthly performance since May 2010.

“Risk assets have made its high, which means basically you have to look for weak stock markets, you’ve got to look for credit spreads to increase, high-yield bonds to get into trouble, the dollar to rally, and commodity prices to come down.”
He forecasts the S&P 500 to decline to 1,000 points in fairly short order. The S&P 500 closed Friday down 0.2 percent, the seventh down week in the last eight.

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