Development of the risk trade

December 17, 2009

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- Jane Foley is research director at Forex.com. The opinions expressed are her own.-

A willingness to differentiate between risk on a country or at a regional level is an important part of the repair process in financial markets.

Credit worthiness is at the core of any assessment of risk and naturally credit worthiness can sort “risk” into a hierarchy which should be instrumental to the pricing of assets and currencies.

At the start of this year, fear and uncertainly herded investors in and out of “risky” investments fairly indiscriminately. Even though the overall rally in risk since the spring suggests that broad based fear has been dispersing, strong correlations between some of these “risky” assets persist.

Forecasts of slow levels of growth for most of the G10 in 2010 suggests that there are still a few more negative shocks in store for the markets in the coming months.

That said, reduced levels of fear should allow fundamentals including assessments of credit worthiness to play a greater part in asset allocations.

This should result in many of the correlations that have characterised markets during 2009 to break down. Rather than move indiscriminately in and out of “risk”, markets will gradually return to assessing individual markets or sectors on their merits.

During the course of 2009, a strong correlation has been sustained between stocks, oil prices, the Standard & Poor’s 500 and euro or Japanese Yen with the dollar index inversely correlated with these “risky” assets. The Australia and U.S. dollars started the year trading in line with “risky” assets but since the spring, Australia‚Äôs exceptionally good economic fundamentals has allowed it to outperform.

In the foreign exchange market there are now signs that the U.S. dollar has given up its inverse correlation with “risk” and is in the process of handing back the mantle of prime funding currency back to the Japanese yen. Earlier this month, the Bank of Japan set up an emergency Japanese yen 10 trn credit facility.

Given that Bank of Japan rates are at 0.1 percent, well below the 0.25 percent level of Fed funds, the Bank could be seen as encouraging the use of the Japanese yen as a funding currency. On top of this the Bank had a bit of good luck.

The shock positive U.S. November payrolls release shook up expectations in the market with respect to the first Fed rate hike of the cycle.

Speculation that the first Fed rate hike of the cycle could come earlier than previously thought was heightened by the strength in the U.S. November retail sales number released last week.

The U.S. dollar and Japanese yen have roughly been following movements in the short-end of the curve in the last few weeks and if the market continues to believe that U.S. rates will be moved higher, perhaps in Q3 2010, then the dollar and the yen could indeed continue to trend higher and the dollar index could carry on steering away from its recent lows.

researchEMEA@forex.com

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