The conventional wisdom about trading is that there are two dimensions traders work within to shape their trades: fundamentals and technicals. Fundamental analysis looks at the economic conditions that influence price movements, while technical analysis looks specifically at price movement, believing that the fundamentals are worked into the price.
The main fundamental forces for forex markets are interest rate differentials, economic growth and inflation expectations. In normal times, the most important fundamental force is interest rate differentials. This force results from the attraction of a return on leveraged investment when a differential in rates occurs. When hundreds of millions of dollars are resting in cash, the goal is to get paid on interest income. If the difference in rates among currencies is great, it results in the strategy where investors and traders borrow the lower interest currency and invest in the higher interest currency or assets of that currency. This strategy is known as the carry trade.
For years, carry trade strategies made a lot of sense and received superior returns. Yet the risk of having the borrowed currency fall in value and then having to buy it back with losses is what carry traders always fear. Through the years, the carry trade strategy had swings in fortune as world economic trends changed. Retail traders can track carry trade conditions by monitoring the I Path Optimized Currency Carry ETN (ICI), which tracks the carry trade strategy and its price path (see “Carried away”). The carry trade has collapsed, demonstrating that risk aversion dominates. The question is, how can the currency trader detect a return of risk appetite?
While there is no single accepted measure of risk appetite, we can start with the relationship between the Japanese yen and equity market volatility as measured by the VIX index. In high volatility conditions money tends to flow back to “safe-havens.” “A yen for less risk” shows that the yen follows the VIX. More volatility coincides with a stronger yen. A slowdown in volatility leads to less demand for yen. Currency traders should monitor the VIX to determine market sentiment.
If we overlay ICI, with USD/JPY, and an inverted VIX, we can see the contours of risk sentiment in the current market. “No appetite for risk” compares an inverted VIX against the ICI and the USD/JPY currency pair also shows us a very interesting synchronicity.
The challenge for the forex trader will be to detect a change in global financial conditions, which will show a shift from risk aversion to risk appetite. Strategies that use only one market or instrument are very limited. By using several different markets and instruments, the trader will be able to map global sentiment with a greater degree of accuracy and perhaps be a step ahead when the larger universe of traders is ready to put on more risk.
Abe Cofnas is the author of “The Forex Trading Course” and “The Forex Options Trading Course” (Wiley). Reach him at abecofnas@gmail.com.
