Since last Thursday, carry trades have performed very well. USD/JPY has risen over 250 pips and the Dow appears to be carving out a near term bottom. This has led some investors to wonder whether whether risk appetite has returned.

The stock and credit markets have been stabilizing over the past few months and thankfully, no bank has fallen victim to the same type of demise as Bear Stearns.

According to an article in the Wall Street Journal today, “a growing number of economists — including some who not long ago were saying a recession was all but inevitable” are now taking a detour.

The 325bp of easing delivered by the Federal Reserve and the distribution of fiscal stimulus checks has forced many economists to reduce their odds of a recession. Wachovia for example revised their probability of a recession from 90 percen in April to 45 percent. Economic data has been stabilizing and we also see the market’s improving risk appetite reflected in the Treasury markets and the CBOE Volatility Index.

The VIX, which measures the volatility in the stock market has hit the lowest level since October indicating that market jitters are subsiding:

Source: Bloomberg

There has also been a surge in US Treasury yields. Looking at the details of the 10 Year US Treasury yield, we see that the gap between the real yield and the inflation premium has contracted significantly from its March post Bear Stearns’ highs.

Be Cautious

Although it is clear that the risk appetite of the market is improving, there are plenty or reasons to believe that danger still lies ahead. The ongoing rise in gasoline prices, falling house prices and the increasing level of foreclosures poses a big risk for consumer spending in the months ahead. Also, there is a strong chance that job losses will continue to climb.

Even though risk appetite has improved, be careful of a burst in volatility because whenever volatility in indices such as the VIX hits extreme levels, a reversion to the mean may be right around the corner.