interest rate swaps in Chapter 4 on interest rate differentials and expectations.
6. Corporate spreads/credit default swaps
In determining the market’s appetite for risk, traders also keep a close eye on the spread between US corporate high-yield debt and the equivalent US investment-grade bond (US Treasuries). If the spread between the two instruments widens dramatically because the corporates need to offer a higher yield to woo investors, this is a red flag for risk, whether for the market as a whole, or that particular company. Whether a triple-A corporate or a junk name, savvy FX players try to watch how these spreads are trading.
A company or country’s credit default swap (CDS) is also monitored by traders. A Federal Reserve research paper updated in February 2011 [8] explains the fundamentals of a credit default swap agreement:
“Under a CDS contract, the protection seller promises to buy the reference bond at its par value when a predefined default event occurs. In return, the protection buyer makes periodic payments to the seller until the maturity date of the contract or until a credit event occurs. This periodic payment, which is usually expressed as a percentage (in basis points) of the bonds’ notional value, is called the CDS spread. By definition, credit spread provides a pure measure of the default risk of the reference entity. We use CDS spreads as a direct measure of credit spreads. Compared to corporate bond yield spreads, CDS spreads are not subject to the specification of benchmark risk-free yield curve and less contaminated by non-default risk components.”
Country risk can be gauged by watching CDS spreads also. Indeed, throughout the euro zone debt crisis, traders kept a close eye on peripheral spread widening, in both the CDS market and in spreads over German Bunds. Greek five-year CDS spreads (Greek CDS over the equivalent of German Bund CDS) widened to a record 1,385 basis points in April 2011, only to push well over 1,600 basis points in June.
What exactly does this insurance policy mean? It would cost $1.6 million dollars annually to insure $10 million in Greek debt for five years. Greek five-year spreads over Bunds, which already stood at a stretched 950 basis points in early January 2011, widened to a record 1,509 basis points in early August.
It should be noted that, despite Greek CDS spreads hitting record highs and two-year Greek yields reaching nearly 43% in August, the euro exchange rate maintained roughly a $1.40 to $1.45 range, far closer to the 2011 highs near $1.4850-$1.4940 seen in May than the 2011 lows around $1.2875 seen in January. The widening of Greek CDS, while a clear euro negative, was not enough to offset the combination of uncertainty about the US dollar and reserve diversification by world central banks (a topic covered in more detail in Chapters 10 and 11).
7. Price of commodities
FX traders watch commodity prices as an inflation barometer as well as for insight into which commodity currencies to buy or sell. Select commodities, especially the precious metals, are viewed as a gauge of risk. For instance, spot gold prices and futures prices are closely eyed, along with gold exchange traded funds (ETFs). Rising gold prices may mean that the market is concerned about inflation or that investors are too afraid to buy anything else. Similarly, the rapid run-up in crude oil prices in 2011, especially Brent crude, indicated that market players were concerned less about reduced supply in the wake of Middle East/North African turmoil, and more about the risk of prices doubling. Fear of the unknown drove prices, rather than pure supply and demand concerns.
Ask a precious metals trader why spot gold reached a life-time high of $1911.46/oz in August 2011 and he will give you a laundry list of reasons, namely low US interest rates, inflation concerns and rising global demand. At the same time, he will say that fear of the unknown and fear of investing in other instruments also played an important role.
Some traders track the Thomson Reuters-Jefferies CRB Index and watch for anomalies in its price action as a risk gauge. The CRB has been around for over 50 years and began in 1957 when the Commodity Research Bureau constructed an index comprised of 28 commodities, two spot markets and 26 futures markets for investors to trade. The index has evolved over the years, with the number of commodities later pared back. In June 2005, the index was renamed the Reuters/Jefferies CRB index and included 17 commodities, all on a futures basis. The present Thomson Reuters-Jefferies CRB Index includes 19 commodities.
Of the weightings given to the various commodities, Group One (WTI crude the highest weight of 23%, heating oil and RBOB gasoline each 5%) has a 33% weight, Group Two (natural gas, corn, soybeans, live cattle, gold, aluminum, copper all 6%) has a 42% weight, Group Three (sugar, cotton, coffee, cocoa all 5%) has a 20% weight, and Group Four (nickel, wheat, lean hogs, orange juice, silver all 1%) has a 5% weight.
As of 4 January 2012, the CRB has a ten-year annualised return of 4.73%. [9] This is favourable compared with other tradable commodity indexes – the Dow Jones UBS commodity index return was at 4.58% and the S&P GSCI commodity index was at 3.46%. The Sharp ratio (measure of risk premium per unit of risk) is 0.4x for the CRB, 0.3x for the Dow/UBS commodity index and 0.1x for the S&P GSCI. What this signals to FX traders is that commodities are, as the portfolio optimisation orthodoxy has it, a high-risk but profitable alternative investment to conventional equities and bonds. When investors are feeling frisky and want to embrace risk, they will buy commodities and this is a signal that demand for the dollar as a safe-haven is waning.
Conclusion
Currency traders, like soldiers in battle, utilise the best available radar to ascertain how the war is going and how to develop the best offensive and defensive tactics. The use of risk indicators helps them formulate their worldview. We must stress that these indicators are not infallible and don’t always dictate dollar direction exactly, or how long an FX trend will last. In terms of a shift in the risk trend or the extension of a risk trend, while there are clear ramifications for FX, it is not always clear what they are.
For example, during the first half of 2012, the CBOE’s VIX spent a good portion of its time in risk friendly, sub-20 territory. Even as the crisis in the euro zone escalated and Greece held a second run-off election and Spanish banks were bailed out, the VIX could not even break above 30, let alone retest the 47.56 high seen in 2011. An FX trader using the VIX alone as a risk gauge might not have known to expect the sizable safe-haven dollar demand that was seen during the first half of the year.
In addition to risk indicators, FX traders keep a close eye on existing positions and country flows, which we will explore more in Chapter 6.
Endnotes
4 Birgit Uhlenbrock, ‘Financial markets’ appetite for risk – and the challenge of assessing its evolution by risk appetite indicators,’ Bank for International Settlements, IFC Bulletin No. 31. [return to text]
5 Laura E. Kodres and Matthew Pritsker, ‘A Rational Expectations Model of Financial Contagion’, www.federalreserve.gov/pubs/feds/1998/199848/199848pap.pdf [return to text]
6 Craig S. Hakkio and William R Keeton, ‘Financial Stress: What Is It, How Can It be Measured and Why Does It Matter?’ Kansas City Fed Q2 2009 Economic Review. [return to text]
7 research.stlouisfed.org/publications/net/NETJan2010Appendix.pdf [return to text]
8 www.federalreserve.gov/pubs/feds/2011/201102/201102pap.pdf
