The Currency Carry Trade, DBV and Risk

Anyone who has been active in the financial markets during the past five years knows that there are many types of risk, many ways to think about and measure risk, and invariably some risks lurking around the next corner that many of us have never bothered to contemplate. Most investors tend to focus their attention on equities and therefore have a tendency to think in terms of the CBOE Volatility Index (VIX) and use that number to evaluate the relative level of risk, uncertainty or perhaps fear in the markets. That being said, during the past few years, almost everyone has become conversant in such topics as credit default swaps, the TED spread, the LIBOR-OIS spread, bank capital ratios and a whole host of concepts and statistics which were not on their radar in 2007.

For a more holistic approach to evaluating risk, there is always the St. Louis Fed’s Financial Stress Index, which is one example of an attempt to aggregate a variety of risk factors (18 in all) related to economic and financial matters into a single risk index.

One aspect of market risk that many investors continue to struggle with is the currency carry trade. If the daily movements of the dollar are relatively unimportant for those interested in buying and selling stocks that are primarily based in the U.S., then it is relatively easy for most investors to conclude that the gyrations of the Japanese yen (FXY) or Australian dollar (FXA) can be dismissed as much less important than those of the dollar. Unfortunately, this is not always the case. It turns out that many investors, particularly large institutional ones, have an appetite for the currency carry trade, in which one borrows in a currency where interest rates are low and uses the proceeds to buy assets in a currency where interest rates are higher. With Japan’s central bank targeting interest rates of 0.1% and the Reserve Bank of Australia recently cutting its base rate to 2.75%, the carry trade is structured as an interest rate differential trade in which an investor can borrow in yen and then buy Australian bonds, with profitability determined by the net interest rate differential plus or minus any fluctuation in the exchange rate.

Naturally some more aggressive investors prefer to use the yen as a funding currency for the purchase of assets other than bonds, including U.S. stocks. The problem for investors in U.S. stocks is that when the yen appreciates sharply – as it did on Monday and Thursday of last week, as well as during today’s session – traders with short yen positions who are victimized by a short squeeze will be subject to margin calls and/or forced liquidations, which means that not only are they covering their short yen positions, but they are also selling any long positions in U.S. equities as both legs are unwound. For this reason, when the yen carry trade is in favor, U.S. equities tend to move in the opposite direction of the yen. Traders can monitor the strength of the yen by following the USD/JPY currency cross or the Japanese yen ETF, FXY.

An alternative to focusing entirely on the yen is to monitor the PowerShares DB G10 Currency Harvest Fund (DBV), which, as PowerShares indicates, “is composed of currency futures contracts on certain G10 currencies and is designed to exploit the trend that currencies associated with relatively high interest rates, on average, tend to rise in value relative to currencies associated with relatively low interest rates. The G10 currency universe from which the Index selects currently includes U.S. dollars, euros, Japanese yen, Canadian dollars, Swiss francs, British pounds, Australian dollars, New Zealand dollars, Norwegian krone and Swedish krona.”

In other words, DBV is a carry trade ETF that is short three currencies and long three currencies at all times, updating these holdings on a quarterly basis. The ETF is currently short the Swiss franc, the euro and the yen, with long positions in the Australian dollar, the Norwegian krone and the New Zealand dollar.

As the chart below shows, DBV has been tracking the S&P 500 index quite closely for most of the past year, but that relationship has recently broken down as DBV has plummeted while the SPX has experienced only a mild pullback. Going forward, investors should strongly consider keeping an eye on the USD/JPY cross, the FXY ETF (which is optionable) and also DBV, which provides a much broader picture of the overall carry trade – and can also serve as a proxy for the risk this trade can pose to stocks.

[In addition to the products referenced above, note that there is a currency carry trade ETF that is similar to DBV, the iPath Optimized Currency Carry ETN (ICI), but this product has considerably less liquidity.]

[source(s): StockCharts.com]

Related posts:

• Suppressing Volatility and the Black Swan of Cairo
• Thinking About Volatility
• The Credit Default Swap Canary
• The Risk Library
• A Conceptual Framework for Volatility Events
• Forces Acting on the VIX
• The St. Louis Fed’s Financial Stress Index and Market Risk
• VIX and St. Louis Fed’s Financial Stress Index Moving in Concert
• Zooming in on the St. Louis Fed’s Financial Stress Index
• St. Louis Fed’s Financial Stress Index

Disclosure(s): none

St. Louis Fed’s Financial Stress Index

When I started this blog, I added what sounded like a whimsical tagline at the time, “Your one stop VIX-centric view of the universe.” In retrospect, perhaps the joke was on me, as the content here has consistently been VIX-centric, despite my occasional forays into that “and More” netherworld.
I will be the first to admit, however, that the VIX captures only a small slice of investor sentiment and represents only one type of threat to the markets.

Back in March 2007 I addressed a broader range of sentiment indicators when I wrote A Sentiment Primer (Long) and urged investors to take a broad-based view of threats to the market in The Credit Default Swap Canary. Along the way, I have been a strong proponent of using put to call ratios (Put to Call Everest), bond yields, the VIX divided by T- bill yields (VIX:IRX), the TED spread, counterparty risk measures, and other factors.

One excellent index which attempts to capture a broad range of components of financial stress is the St. Louis Fed’s Financial Stress Index, henceforth to be known here as the STLFSI. The index constituents are highlighted below and include an interest rate group, a yield spread group and an third uncategorized group of additional indicators in which the VIX is one of five components.

Interest Rates:

• Effective federal funds rate
• 2-year Treasury
• 10-year Treasury
• 30-year Treasury
• Baa-rated corporate
• Merrill Lynch High-Yield Corporate Master II Index
• Merrill Lynch Asset-Backed Master BBB-rated

Yield Spreads:

• Yield curve: 10-year Treasury minus 3-month Treasury
• Corporate Baa-rated bond minus 10-year Treasury
• Merrill Lynch High-Yield Corporate Master II Index minus 10-year Treasury
• 3-month London Interbank Offering Rate–Overnight Index Swap (LIBOR-OIS) spread
• 3-month Treasury-Eurodollar (TED) spread
• 3-month commercial paper minus 3-month Treasury bill

Other Indicators:

• J.P. Morgan Emerging Markets Bond Index Plus
• Chicago Board Options Exchange Market Volatility Index (VIX)
• Merrill Lynch Bond Market Volatility Index (1-month)
• 10-year nominal Treasury yield minus 10-year Treasury Inflation Protected Security yield (breakeven inflation rate)
• Vanguard Financials Exchange-Traded Fund (VFH)

The chart below shows the performance of the STLFSI and the VIX going back to 1993. Not surprisingly, there is a high degree of correlation. If one accepts the STLFSI as a more broad measurement of stress in the financial system, one can make a case that while the VIX is usually directionally correct, at certain times the VIX has underestimated the stress in the system (e.g., May 2008) while at other times the VIX has overestimated the stress in the system (e.g., May 2010). Going forward, I will make an effort to flag important divergences between the VIX and the STLFSI.

Note that the Kansas City Fed has a similar Financial Stress Index, aka the KCSFI, which is more concise and more focused on yield spreads.

The St. Louis Fed has more information on the STLFSI here, while the Kansas City Fed has more information on the KCSFI here.

Related posts:

• Revisiting the Flight-to-Safety Trade
• Chart of the Week: The Flight-to-Safety Trade
• The Credit Default Swap Canary
• A Sentiment Primer (Long)
• Chart of the Week: Record Low Yields for the 2-Year U.S. Treasury Note
• Chart of the Week: 10-Year Treasury Note Yield
• Chart of the Week: Ratio of VIX to Yield on 3 Month T-Bills

[source: Federal Reserve Bank of St. Louis]

Disclosure(s): none

Three Fear Indicators (or…The Three Baritones)

While the VIX gets most of the media attention as a fear indicator, its usefulness is clearly much better for volatility related to U.S. equities than it is for other asset classes and economic threats.

The TED spread received considerable acclaim in 2008 as measure of liquidity and a reasonable proxy for counterparty risk. Of course gold had been around the longest of all and has served as a barometer of risk for all types of investments and other risks for centuries.

In the chart below, I have overlain the VIX, TED spread and gold against a backdrop of a declining SPX for the past year. Note that the TED spread peaks first among the three, during the second week in October, and subsides rather quickly, as liquidity issues recede to the background. The VIX is next to peak, but it too begins to head down toward the end of November as fears of systemic meltdown slowly begin to subside.

The most interesting line on the chart is that price of gold, which actually bottomed in mid-November and has risen sharply over the past three months, partly as a safe haven for panicky investors, but also as a hedge against the risk of inflation due to various fiscal policy approaches that governments are taking in order to rejuvenate the economy.

In summary, the TED spread has retraced its entire September-October spike, the VIX has retraced about half of its September-November spike, and gold appears to have paused after retracing about 20% of its November-February move. The TED spread and the VIX look like old news at the moment, with the possibility that gold may be the best fear indicator for current market conditions.

[source: StockCharts]

2008 Volatility Awards

I thought I’d spare everyone a silly sounding name like “the VIXies,” so without further ado, here are the highly subjective and not-otherwise-nicknamed VIX and More volatility awards for 2008:

• Best New Volatility Index: India VIX
  
  
• Best New Volatility Product: VIX Binary Options
  
  
• Best New Free Volatility Tool: International Securities Exchange’s Quotes/Volatility Chart and Information
  
  
• Best Previously Ignored Volatility Indicator: TED Spread
  
  
• Best New Blog with a Volatility Focus: Don Fishhback’s Market Update
  
  
• Best New Volatility Webcast: optionsMonster’s Volatility Sonar report
  
  
• Top Volatility Event: Lehman Brothers Failure
  
  
• Best New Volatility Book: The Volatility Edge in Options Trading: New Technical Strategies for Investing in Unstable Markets – Jeff Augen
  
  
• Best Volatility Trade of the Year: SPX Options Carpet Bomb on October VIX Expiration (124% and $180+ million in four trading days)

I’m sure I overlooked some other obvious awards. Feel free to add to this list in the comments section.

Watch Emerging Markets Bonds

I know a number of equities-only investors who have started following the bond markets for the first time ever over the course of the past year after becoming tired of being blind-sided by inter-market relationships.

Of the many credit market data points, LIBOR, the TED spread, OIS-LIBOR and others have received a fair amount of press as of late as measures of liquidity. More traditional bond market indicators focus more on risk than liquidity and include the spread between corporate and government bonds or between investment grade and high yield corporate bonds.

I want to suggest another bond market indicator – one that can provide a reflection on the workings of the global economy. The PowerShares Emerging Markets Sovereign Debt Portfolio is an ETF that carries the ticker PCY. Launched in October 2007, the one year chart shows historical volatility in the 5-10% range prior to the Lehman Brothers collapse last month. Historical volatility is now above 100% after a month and a half of pure chaos. As the chart below shows, PCY lost almost half of its value during the past month and appears to have bottomed last Friday. Note the new buying interest over the course of the last few days, as investors have sought out emerging markets debt as a value play.

In many ways, emerging markets are the focal point of many of the issues facing today’s global economy, from the credit crisis to the demand for commodities to the prospects for renewed global growth down the road. Keep an eye on PCY, not only as an indicator, but also for its investment potential.

[source: StockCharts]

TED Spread and VIX Both Coming Back to Earth?

It remains to be seen whether yesterday’s new high of 81.17 in the VIX turns out to be the top in that index. Personally, I think there is a good possibility that 81.17 holds up for many years, but I also believe that it is even more likely that the TED spread (which measures the difference between LIBOR rates and the yield on the 3 month U.S. T-Bill) high of last Friday will mark the maximum point of atherosclerosis in the credit markets.

In the graphic below, courtesy of Bloomberg, you can see that the TED spread has already pulled back about 14% from the October 10^th high.

Even a slow thaw in the credit markets and in equity volatility should be a sign that the global economy is turning the corner. In fear and panic there is opportunity; and as we turn the corner, the opportunities are greatest.

[source: Bloomberg]

Measuring Stress in the System

Historically, the VIX has been an excellent proxy for measuring the level of anxiety and stress in the financial markets…but not always the best one.

Back in early March 2007, I suggested credit default swaps – and particularly the Markit indices – as a way to monitor how the markets are pricing in the risk of defaults. Another common way to monitor default risk is to look at the yield spread between corporate bonds of various rating categories versus the (presumably) riskless US Treasury debt of comparable maturity.

Let me nominate a third alternative: LIBOR rates. LIBOR (formally the London Interbank Offered Rate) is essentially the established rate at which banks lend to each other. Normally LIBOR rates track the Fed Funds rates fairly closely, but lately the LIBOR rates have remained elevated even as the Fed has acted to cut rates and attempted to inject liquidity into the system. If you want to get a sense of how effective the Fed has been in easing tight credit, LIBOR rates (and the "TED spread," which is the difference between LIBOR and the Fed Funds rate) are a good place to start. As the chart below shows, even though LIBOR rates may have topped a month ago, they remain quite elevated when compared to the August-December period.

For more detailed discussion of LIBOR, the Fed, and the current credit crisis, a good place to start is Michael Shedlock’s Failures of the Term Auction Facility – which is decidedly not for the faint of heart.