How To Identify When The Risk Tone Has Changed?

Strength or weakness in equities, commodities, bonds, volatility indexes and high beta / safe haven currencies help traders identify a changing risk tone.
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Identify Change In Market Risk Tone

We just have a quick question from Jean Pierre. Jean Pierre is saying that he wants to know exactly what data we use to determine sentiment shifts from risk tone. So whether we are seeing a sentiment shift in a risk on a risk off tone.

Now, I’ve just quickly drafted a very quick Excel spreadsheet, just to help us with this, to understand it, seeing it a little bit more visual.

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Now let’s start with equities. When we have a strong risk off tone, meaning that investors doesn’t really have an appetite to take on risk we would normally see your high risk assets like stocks or equities trading down across the board, you’ll see your higher risking commodities like copper and oil, remember copper is normally called Dr. Copper as it acts like a thermometer for risk sentiment. So you should see oil and copper prices down across the board.

You should see your traditional safe haven commodity, gold trading up. You should see your high risk, high beta, higher yielding currencies like your Aussie, CAD, Kiwi and emerging market currencies trading down. You should see your safe havens like the Swiss franc and the Japanese Yen trading up.

Another area that we can look at, another asset class is bonds whenever we have safe bonds, like government bonds like treasury bonds, when we have a risk off environment, you should see support for government bonds. Now remember that government bonds move inversely to the yield. So whenever we see upside in the government bonds that should see downside in the yields, so just make sure to make that differentiation.

Then also, looking at corporate bonds, which is the more riskier one that should actually be trading down, especially the lower grade ones. Then looking at credit spreads normally, you’ll see credit spreads widening.

Now, a credit spread will be the difference in the yield between a government bond and a corporate bond of the same maturity. So let’s say 10-year Treasury yields or treasury bonds versus, 10-year Treasury yields versus your corporate yields of the same maturity, you should see that widening. And then also in terms of volatility, you should see volatility indexes like the VIX trading up.

There’s also other volatilities that you can look to which is OVX which is the volatility for oil, GVZ the volatility for gold and TYVIX which is the volatility for treasury yields or treasury bonds.

That should also be trading up in terms of volatility. When we have a risk off tone, we normally see the exact opposite happen. So then will see equities trading up, we’ll see oil and copper prices trading up, gold trading down, high beta, high risk, high yielding currencies like emerging market currencies, as well as Aussie, Kiwi, CAD trading up, we’ll see safe havens like the Swiss and the Yen trading down, we’ll see safer government bonds, like US Treasury bonds trading down. We’ll see higher risk, higher yielding corporate bonds trading up.

We’ll see credit spreads between government yields and corporate yields of the same maturity narrowing, and we’ll also see downside in terms of VIX, OVX, GVZ as well as TYVIX. Now, these three normally it’s very rare, in very rare circumstances do we see all of them spike.

Now, the current environment that we’re trading in obviously, is a very, very unique environment. It’s unprecedented what we’re seeing in the markets, we are entering into a global recession, we’ve seen economic data points that we haven’t seen in terms of the history of economic data points.

So just keep in mind that this is the traditional things that we can look at for risk on, risk off flows, but don’t be surprised if we see a few dislocations here and there, especially in risky environments that we’re trading in now.

We have seen some dislocations on days where stocks and gold has been trading up on the same days and trading down on the same days, as well as government bonds, so there has been some dislocations, but this is generally the type of indicators that we can look to, to determine the overall risk on or risk off tone that we see in the market. So I hope that helps you out there, Jean Pierre.

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