THE DAYS when we would experience broad-based US dollar gains or sell-offs are long gone. With forex volatility reaching new lows, traders need to adapt and turn picky when choosing which currencies to trade. So what has been (and will likely continue to be) a good leading indicator of volatility?
RELATIVE YIELD SPREADS
With the European Central Bank cutting rates last month, the relative yield between the Eurozone and the UK moved in the favour of the latter. The effect on euro-sterling was strong and is still evident on price. This is a prime example of how relative yields move the markets, as money will usually flow to the country which is expected to have the highest relative yields. Some will draw an analogy with choosing between savings accounts at two major UK banks. If the banks’ default risk and service is the same, investors will naturally deposit their savings at the bank which offers the highest interest rates.
This is called the carry trade and, in the absence of a heightened risk of recession in one of the major economies, the carry trade is what will dominate investors’ minds. In the case of a heightened risk of recession in one of the G7 countries, the potential risk will usually outweigh potential return. This will cause the flow of hot money to reverse. In this case, the prior stars – countries with the higher yield – will usually suffer. On the other hand, the countries with low yields, which were the funding currencies, will shine. This phenomenon is known as the “risk off” scenario.
For more on this feel free to read – http://bit.ly/YieldCityAM
Alejandro Zambrano is a currency strategy analyst at DailyFX.com. Twitter; @AlexFX00