From the April 2014 issue of Futures Magazine • Subscribe!

A return to honest carry…and volatility

A Balancing act

In an ideal world, economic and financial conditions would catch up to speculative positioning and substantiate the levels and exposure markets have sought. Yet, “ideal” tends to be academic rather than practical market application. Where is the tipping point for the grander scale of risk vs. reward? How proactive will the world’s monetary policy leaders be in trying to curb or prevent the scale down in risk?

Many central bankers, political officials and prominent economists have voiced their concern over what the removal of stimulus can do to the global markets. Yet, the costs accompanying QE3 are also starting to be taken more seriously amongst their ranks. Some vocal hawks (such as Dallas Fed President and voting FOMC member Richard Fisher) have even voiced concern that such extreme accommodation has distorted markets by encouraging excessive risk taking (see Cover Story, page 14). And though his is not a popular opinion amongst his international colleagues — at least not publically—concerned central bankers like Fisher have even said the situation is so unbalanced that they support a withdrawal of the extracurricular support even through a significant market correction.

This evolving view is important to appreciate. The shepherds of the market are tacitly—and in some cases explicitly—acknowledging the excesses of the market. Furthermore, they are committing to letting some of the air out to prevent another financial disaster and a stimulus-resistant strain of investor fear. In this way, monetary policy can spark another wide-spread shift in speculative sentiment, but this time it is a bearish threat.

In the event of a broad deleveraging move, the forex market will quickly realign to its traditional risk positioning. Those currencies that have suffered under the monikers of “safe haven” or “funding currency” during the past five years will be best positioned to gain. The U.S. dollar is undoubtedly the favored refuge should fear leverage appetite for liquidity. The Japanese yen fits the mold a little differently as it was used to build the carry trade, which would thereby appreciate as the position was unwound. Alternatively, the market’s investment currencies, such as the Australian and New Zealand dollars, will be most exposed while those that took advantage of low liquidity conditions to advance (Euro and Pound) would similarly face headwinds.

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