While the DailyFX Carry Trade Index was modestly higher over the past week, the strategy (and overall risk sentiment) is on the verge of a breakout with earnings season kicking off and signs of a deepening financial crisis popping up all over the market. Today, the carry index stood at 28,935 – 101 points above last Friday’s level. However, looking at the chart below, it is easy to grasp the pressure building behind an inevitable break in the market’s cautious stance.
Since May, the basket has cut an ascending wedge with a horizontal resistance around 29,050. Perhaps offering a bias for the eventual trend development, market condition indicators are actually working their way lower despite improvements seen this past week. USDJPY risk reversals corrected considerably from its highest levels since last October and the volatility index is holding above the critical 10 percent figure.
The rebound in risk appetite seen from the March swing low has been slowly curbed by various signs that credit conditions and a lack of liquidity are still burdening the financial markets. Recently, a Bank of England credit report forecasted that the credit market – the life blood of investment – would worsen through the third quarter.
Such a forecast is troubling considering European banks are paying the highest prices in a decade to raise capital just to meet reserve requirements, while the governmentally sponsored Fannie Mae and Freddie Mac in the US are paying record yields in their own efforts to fortify reserves.
In the weeks ahead, speculation that these two lenders may require a government bailout or face bankruptcy will help to define the overall direction of risk trends; and the debate is lively. St. Louis Fed President William Poole has suggested the government step in now as the companies are essentially insolvent. Another driver for risk trends and the carry trade will be banks’ second quarter earnings numbers, which start to hit the wires next week.
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