forex

Since the broad sell off in risk-related assets back in July and August of last year, caution has dominated the market’s taste for risk. The change in sentiment has increased the danger of holding carry trades which rely on low volatility and steady infusions of capital into the financial markets to prevent dramatic fluctuations in the spot rates of currency pairs that lead to capital losses. Now at the start of a new trading week, it is hard to refute the pervasiveness of risk aversion.

In equities, panic selling steeped the world’s benchmark indexes into remarkable declines. Starting in Asia, the Nikkei fell 3.9 percent as Friday’s late sell off in US markets produced an echo in eastern markets. However, as European markets came online, it was clear that Monday’s jump in volatility would be more intense than a mere sympathy move. The region’s financial centers all marked dramatic losses: the FTSE 100 fell 5.5 percent; the French CAC 40 tumbled 6.8 percent; and the German DAX Index plummeted 7.2 percent. For the carry trade, this has meant severe losses for the yen crosses, and indeed large declines for all pairs that have carry-related interest. With today’s jump in volatility, the carry trade has established a 10.6 percent draw down – the worst since May of 2006, and nearly a record.

And, while a low seems to have been set for the carry trade with the Asian and European markets’ close, a new record may be just around the corner. In Monday’s global selloff there was a notable absence from the US. The Martin Luther King holiday has delayed the American market’s reaction to the worst equity selloff since September of 2002. However, it was clear from price action in the futures markets that tomorrow’s open would see the US market playing catch up to the sharp losses. In holiday trading, the active Dow Index futures contract dove 514 points or 4.25 percent. With fears of an imminent US recession, worsening credit markets and a potentially volatile FOMC rate decision next week weighing on investors; it looks as if conditions for the carry trade will only worsen before they get any better.

Despite the recent injections of liquidity by the world’s most important central banks, the global financial system remains vulnerable and the outlook for carry trade is still very bearish. Last week, the DailyFX Dynamic Carry Trade Portfolio was down by 854pips. The most unprofitable trade was the position we held in the New Zealand dollar with 411 pips gain in capital losses offset by $39 on interest payments accumulated along the last 5 days. Looking ahead, the Federal Reserve is expected to cut the Fed Funds rate by 50 bps when the FOMC holds its next meeting in January 30, 2008. According to futures trading on the Fed Funds rate, traders are fully pricing a 50 bps rate cut and as much as 46 percent probability of a 75 bps rate cut to 3.75 percent. The rate cut is likely trigger a major recovery in the U.S. stock market and help all classes of risky assets, including carry trades.