Peculiarities of risk-on and risk-off strategies
Forex is relatively young and many of its working principles have been borrowed from the securities market. Earlier, the investors used to get rid of shares and buy bonds when the risk of a global economic recession was growing, but now they’ve got an alternative. Forex provides both risky assets and safe haven assets, and their value depends on the global risk appetite. What is it and how can it be used in traders’ practice?
Technical analysis strategies are numerous and varied, but the “fundamentalists” must have heard about such notions as carry trade and risk-on/risk-off. First, we need to know that the category Forex currencies belong to (profitable/high-risk or safe/low-risk) depends on the profitability of local bonds. For example, Japan 10-year bond yield is -0.016%, and the bond yield in Switzerland, Australia and New Zealand is -0.605%, +1.2% and +1.57%, respectively. As a result, the Japanese yen and the Swiss franc are considered to be safe haven assets while the Australian and the NZ dollars - high-yield currencies.
As the global risk appetite is growing, AUD/JPY and NZD/JPY quotes normally rise. Conversely, a decline of the global risk appetite makes them fall. The former situation is called “risk-on” and the latter - “risk-off”. The trick lies in “carry trade”. If investors are sure about favourable prospects of the global economy, they take out loans in the countries with low interest rates and then invest money in high rate bonds. That is to say, they buy high-yield currencies (Aussie) and sell safe currencies (yen). If the forecast turns out to be correct, the investors will profit from both AUD/JPY’s rally and the difference between the rates.
How do we understand whether the risk appetite is growing bigger or weaker? Looking at the behaviour of the US securities will be enough.
Dow Jones and U.S. bond yield dynamics
Source: Trading Economics.
The market confidence in the global economy’s bright future makes stock indexes and bond rates soar at the same time, like it happened in September-December 2019. The investors would buy out shares and sell bonds. The price of the latter was falling and the yield was growing. Safe haven currencies feel quite uncomfortable in such circumstances. For example, the Japanese yen has lost nearly 4% in price since the beginning of autumn and lost a chance of winning the G10 race.
On the contrary, US stock indexes and treasury yields were falling, which pointed to a decrease in the global risk appetite. Carry traders would close trades: they would get rid of risky assets and come back to safer assets to pay off the loans. The background was favourable to the yen that would lead the race from time to time.
There can be situations when the US bond rates and stock market move in opposite directions. It is not that carry trading becomes less efficient, but it needs to become more selective. As a result, both safe and risky assets may grow and fall simultaneously. In such conditions, investors need to use other factors to predict further dynamics of Forex instruments.
It should be mentioned that the matter isn’t only about G10 currencies. The strategies based on developing countries’ currencies are becoming more and more popular these years. Really, why content ourselves with 1.2-1.6% rates when we can benefit from rouble, Brazilian or South American assets at 6.3-8.3%?
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Price chart of AUDJPY in real time mode
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