Risk on… Risk off… We’ve all heard these phrases over numerous occasions the last few years to describe the market sentiment of each individual trading day. This simple characterization for the last few years has been surprisingly adequate to describe the daily performance of various securities. In other words, when risk has been “on”, certain securities have typically gained while others typically lost value, and vice versa.
The same has held true in the Forex market. For instance, whenever risk rallies, the US Dollar usually declines and virtually all other currencies (besides maybe Japanese Yen) typically get stronger. But it wasn’t always this way… There used to be a time when currencies moved more independently of general market risk sentiment. Why has this shift occurred? And will it ever revert back to the old norm, or is this the new normal for currency markets?
First, some background- currencies are theorized to move based on the relative monetary and fiscal policies of the respective countries, in addition to their general level of inflation and interest rates, capital and trade flows, and their prospects for growth. It’s also common knowledge that during times of extreme crisis, the correlations between assets classes gravitate towards one. However, we’re approaching the four-year anniversary since Lehman’s bankruptcy, the event commonly thought of as the climax of the US crisis- so what gives?
From my estimation, the main cause of the change is an increased realization and aversion to risk ever since the crisis. From the second quarter of 2003 to the fourth quarter of 2007, world equities enjoyed a relatively riskless ascension (as measured by the performance of the MSCI ACWI of nearly +130%). After these four and a half years of bliss, the crisis served as a wakeup call and reminder that the world is/can be extremely risky. Ever since, we’ve experienced a sluggish recovery in the US and the onset of the debt crisis in Europe. Now, when investors get any whiff of risk, they flee into safe havens such as US Treasuries, whose purchase necessitates purchases of US Dollars.
Another contributing factor could be the general increase in globalization and integration of markets. Never before have economies all over the world been so interconnected. Hence it would seem to make sense that different countries share the same risk factors.
Lastly, in the developed world at least, there has been a general synchronization of monetary policy. According to theory and holding all else equal, the nation with the loosest policy should have higher expected inflation and thus their currency should depreciate. With nearly all developed nations with policy rates near all-time lows, it’s hard to differentiate the currencies based on carry/rate differentials.
So when will the market revert to its historical trend of reacting to the relative performance metrics between countries instead of this binary risk-on or risk-off ideology? Perhaps once the world is no longer on crisis-watch, which at the very least can only occur once the Euro-crisis is cleared up. In other words- it could be awhile.
Interesting points you bring up in this article. I would like to add that further volatility is created in the markets by the fed holding QE over our heads. Last month it became evident in the equity markets that there were expectations that QE3 was going to take place, causing a week long rally in equities leading up to the fed meeting, and as soon as Bernanke announced that there would be no QE3 there was a sharp correction in the markets lasting for about another week before we were back to the random rumor based swings. At the same time, if one was following the FX and fixed income markets it would've been apparent that there were no true expectations of QE as these markets began to diverge from the INX and DJIA. I think one way of protecting against getting caught up in the superficial swings currently taking place in the equity markets would be to track the divergences in different asset classes as mentioned earlier, especially when there are salient permutations in volume.
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