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Risk Sentiment – Your Ultimate Guide
Okay, after lots of questions from various subscribers about risk tones and risk sentiment, we’ve decided to do a slightly more detailed video than usual, only focusing on the topic of risk sentiment.
Now in the video we’ll discuss three things, first one is what is risk sentiment, the second one, how we can identify it, and the third one, how we can actually go about to trade it.
Three very simple points, but with a couple of nuances that we’ll be spending a little bit more time on individually. Now starting with the first one, what is risk sentiment?
Now in a nutshell, it’s basically just the mood of the market, how the market is feeling right now in terms of their risk appetite. Now the market as we know, is driven by traders who are emotional beings, so when traders are feeling uncertain and fearful. We normally call that risk-off sentiment. That means they will tend to rotate away from riskier assets and rotate towards safer assets, and the opposite is also true.
When traders are feeling greedy and thinking that everything in the market is just unicorns and marshmallows for example, we call that risk-on, and they usually rotate in those type of environments towards riskier assets and rotate away from safer assets. So moving onto the second point, how to identify risk sentiment.
Now, when we evaluate risk tones, we need to incorporate all of the various asset classes into an analysis, we can’t just look at currencies or equities in isolation and that’ll just get us into trouble, we need to consider all of the various asset classes as a whole.
So starting then with equities as a general guide, starting with equities is always a very good idea, because equities are considered one of the most riskier assets out there, and due to its much higher volatility, we often do see them react very fast to sudden changes in the overall risk appetite.
So when we have a strong risk appetite or a risk-on tone, we expect strength for global equities across the board. And when we have very low risk appetite or a risk-off tone, we would expect that to mean weakness for global equities or expect equities on a global scale to depreciate across the board.
Now keep in mind, equities also do have individual factors that can affect prices away from risk sentiment, some things can be individual stock performances, earnings releases, country specific issues, so those type of factors also need to be taken into account, when we see big moves in the equity market.
Then turning to commodities as a general guide, commodities are also considered as riskier assets due to the higher bate, or their higher volatility, and they can also react very fast to changes in the risk tone, but arguably not as fast as the equity markets.
Now looking at commodities like oil and copper, they are considered as riskier assets, but keep in mind you also get commodities like gold, which is considered as a safe haven. Looking at your more riskier commodities like oil and copper, when we have a strong risk-on tone, we expect that to be supportive for higher risk commodities like oil, like copper, and when we have a risk-off tone, we expect that to be negative for commodities like oil and copper.
Obviously it’s different when it comes to gold, gold is seen as a safe haven, so when we have a risk-on tone, gold is actually expected to move down and when we have a risk-off tone, gold is expected to move up. Now keep in mind, as we said with equities as well, there are individual factors that can drive the individual prices for commodities like oil and copper and gold, obviously supply and demand issues is something we need to keep in mind, when it comes to gold for example.
A big consideration for gold, apart from risk tones is actual interest rates or real interest rates, that is one of the key and main drivers for gold prices in the medium to long term, so we also need to keep all of those type of things in mind and not only look at the risk sentiment itself, when looking at things like commodities.
Generally speaking though, the more higher risk commodities like oil, like copper is expected to appreciate in risk-on tones, and depreciate in risk-off and as we said for the safe haven, gold is expected to move down in risk-on and up in risk-off.
Now a fun fact, something like copper is sometimes referred to as doctor copper, as it is considered as a possible leading indicator of cyclical changes in the economy, and can act as a type of thermometer for risk tones. So generally speaking, when we see risk tones or copper move down, that’s normally indicative on a risk-off tone, when we see copper moving up, that’s normally indicative of a risk-on tone, but of course, as we said, we do need to keep individual supply and demand factors in mind as well.
Then turning to something like government bonds, now government bonds, especially government bonds which are considered the safest and the highest ratings in the world, is considered as the safest investments that money can buy, especially when we look at things like the US Treasury Bills, the notes and the bonds, they are considered as one of the safest investments. Thus during times of massive economic uncertainty, we often see lots of demand for US Treasuries, and when we see times of growing risk appetite, or risk-on tones, we often see less a demand for US Treasuries.
Now it’s also important to remember that a bonds yield moves inversely to the bonds price, so when the bond price goes up, such as during risk-off environments, we often see an increase in demand for treasuries and that’ll mean that the yield will go down, contrastingly when a bonds price goes down during risk-on environments, because there’s less a demand for treasuries, we often see the yield go up.
Thus falling treasury bond prices and rising yields are often a sign of risk-on sentiment and rising treasury bond prices and falling yields are often a sign of risk-off sentiment. Now, please keep in mind once again, as highlighted bonds too have individual factors that can affect their overall performance, such as interest rate expectations, thus where we are on the sign curve in terms of the economic cycle is very important, and we also need to keep in mind bond prices can be influenced by other things such as QE.
Now also keep in mind, rising yields and falling bond prices might not be just due to risk tone itself, it takes something like the Italian bond prices and yields as a good example, the higher a country is at risk of possible defaulting on its debt, the lower their demand there will be for their bonds. Thus the yields in those type of countries might be higher compared to something like a US Government bond, so just keep that in mind, basically during signs of immense economic uncertainty, higher risk bonds like Italian bonds with higher default risks such as the Italian bonds and other emerging market bonds will go down in value and thus we will see their bond yields rise despite the fact that we are in an overall risk-off environment.
So just keep that in mind when looking at government bonds, it’s always best to stick to just the US bonds, bills and notes when you’re trying to evaluate the overall risk tone. Then looking at something like volatility, volatility of an assets price is a great indication of the perceived risk in the market, so whenever an assets volatility rises, it usually means that the futures markets are pricing in a higher chance of bigger price fluctuations in the future, which points to expected uncertainty. That is why gauging volatility, especially equity volatility with interim and such as the VIX or the VVIX is such a valuable tool for gauging overall risk sentiment, now as a general rule, higher equity volatility points to risk-off sentiment and lower equity volatility points to risk-on sentiment.
Now there is no perfect level for the VIX, but it has a, as a very generalized rule, a VIX below 15 is considered very low, and is usually expected during times of very low risk and cyclical economic expansion, compared to a VIX above 18, which is usually perceived as a high risk environment, typically found during cyclical economic contractions.
Now, please keep in mind that is very generalized and is vert different during times of massive short-term financial shocks, as during the Global Financial Crisis, or the mid-March crash due to COVID-19, during these type of times, the VIX can shoot to as high as 80, and we often see cross asset volatility spiking up, so a good thermometer during times like that is to not only look at the VIX, but also to look at cross asset volatility as a big market shock or panic will see volatility shoot up across asset classes and won’t only be limited to something like equities.
Then finally turning to currencies. Now, as predominantly spot Forex traders, this is obviously where we usually try and capitalize on risk sentiment through trading typical risk sensitive currencies against each other, so there are basically two types of currencies we need to focus on for risk sentiment, risk-on and risk-off sentiment and that is namely your high beta currencies and then of course, your safe haven currencies.
Now, high beta currencies are currencies which are considered as being more volatile and sensitive to sudden and drastic changes in risk appetite, just like equities, and the major currencies, which are considered as high betas, are usually your Australian Dollar, your Kiwi Dollar and your Canadian Dollar.
They are considered as high beta currencies due to their link and economic dependence on things like commodity prices. Then we also have the safe haven currencies which is considered safe for a variety of different reasons, and are currencies such as the Swiss Franc, the Japanese Yen and the US Dollar.
Now the strength of the US Dollar as a safe haven will largely be dependent on the type of economic environment that we are in, for example, during times of massive global recession, the US Dollar safe haven appeal will be much higher compared to a time of globally synchronized economic recovery just as an example. So looking at high beta versus safe havens, we usually see a very specific reaction from these currencies during specific risk flows.
Risk-on sentiment usually leads to strength or inflows into your high beta currencies, like your Aussie, your Kiwi and your CAD, and leads to weakness or outflows in your Swiss Franc, your Japanese Yen and your US Dollar. Risk-off sentiment usually leads to strength or inflows into your safe havens like the Swiss Franc, Japanese Yen and US Dollar, and leads to weakness or outflows in your high betas like the Aussie, the CAD and the Kiwi. Now, please keep in mind that like most other correlations, risk sentiment is not perfect, and just because a currency is expected to behave a certain way, let’s say during a risk-on or risk–off sentiment, there’s no guarantee that it will happen that way every time.
Just like equities, commodities and bonds, the high beta and safe haven currencies might have other, let’s say individual factors also affecting their strength and weaknesses regardless of the risk tones, so always keep that in mind. So then moving onto the third point, how we can actually look to trade something like risk sentiment.
Now, one of the golden rules in Forex is that we are always trying to pair a strong currency against a weak currency for the highest probability trading opportunity. Thus, when we have a strong risk-on or a risk-off sentiment, a great probability trade would be to pair a safe haven against a high beta currency and vice versa. So let’s look at two simple examples, right. So during risk-on sentiment, we would expect high beta currencies like the Aussie, the CAD, the Kiwi to be supported and we would expect safe haven currencies like the Japanese Yen, the Swiss Franc to be pressured.
Thus buying the Australian Dollar and selling the Japanese Yen, or in other words buying the Aussie Yen pair, would be a great pairing during risk-on environments.
If we have a risk-off sentiment, we would expect safe haven currencies like the Japanese Yen, Swiss Franc and US Dollar to be supported and we’d expect high beta currencies like the Aussie, the Kiwi and the CAD to be pressured, so selling the Aussie and buying the Yen, or in other words, selling the Aussie Yen pair would be a great pairing during risk-off, that is why, also one of the reasons why the Aussie Yen is considered as a very good risk proxy for overall market sentiment, expecting the pair to move up in risk-on sentiment and expecting it to move down in risk-off sentiment.
For the best trading opportunities, you would obviously want the risk sentiment to be aligned with other short-term drivers as well, so lets just take an example, let’s say the markets are expecting the RBA, the Reserve Bank of Australia to cut interest rates due to very bad economic data, just as a hypothetical example.
That expectation for lower rates will obviously cause weakness in the Aussie Dollar, thus if we have a risk-off sentiment as well in play, that would give the Aussie additional reasons to be weak and would be the obvious high beta to choose for a sell against one of the safe havens or any other currency that might be, that might have a particularly strong outlook at that time.
So let’s use the CAD as another example, let’s imagine that OPEC has just announced a massive oil production cut, which is giving oil prices a lift across the board, we would expect that to be supportive for the CAD.
Now if at the same time we also have a risk-on sentiment developing in the market, that would give the CAD additional reasons to be strong and would be the obvious high beta to choose for a buy against one of the safe havens in that risk-on environment, or any other currency that is very weak at that time. Now there are a couple of very important things just to remember about risk sentiment.
The first one is that it’s never just one thing. Various asset classes don’t move in vacuums, right. So all the asset classes are connected and interconnected, which means that the more asset classes point to a specific risk sentiment, the stronger the signal for that sentiment will be. So don’t just assume that risk is off when equities are red, also consider why equities are all red and how other markets are reacting as well.
This is very important. The second one, like most correlations, is risk sentiment is far from perfect. There is no rule that says currencies, equities, commodities and bonds must react in a certain way during specific risk sentiment. That means that just because equities, commodities and bond yields are green across the board, it does not mean that currencies must also follow suit.
We might see high beta and safe haven currencies completely ignore risk sentiment, which would be strange and unexpected, but very possible given the uncertainty present in the financial markets on a daily basis. Thirdly, risk sentiment is not a marriage proposal, right. So markets are driven by traders, who are driven by emotions, which means any sentiment driven by emotions like fear and greed can be very quickly changed as soon as that emotions change, or as soon as a different catalyst shows up on the scene.
So this fickleness means that risk sentiment based rates are best rated as fresh as possible and are usually not the type of trades that you want to keep open for a very long time. Fourthly, knowing why helps to know how.
So, knowing why the market is trading risk-on and risk-off helps us to know how to trade it. For example, if there is no particular short-term sentiment pushing risk sentiment positive or negative, that is usually a very low conviction trading opportunity, which requires more patience and planning.
Now compare that to a risk sentiment trade that is based on a massive catalyst, maybe a possible war declaration or a global pandemic for example, those type of announcements, or maybe massive fiscal stimulus measures being announced.
Those type of announcements, and those type of catalysts can be traded as soon as it hits the wires and it requires little to no patience or planning, you know that that type of announcement will be market moving and it is able to just jump in and ride that wave to the up or to the down side.
So that concludes this ultimate guide to risk sentiment. That should be able to answer most of the recent questions that we’ve had about risk sentiment, and if there are any other questions, please don’t hesitate to let us know.