Risk Sentiment in the FX market
‘Rule No.1: Never lose money. Rule No.2: Never forget rule No.1’. These famous words of the equity specialist Warren Buffett will forever resonate with investors and traders alike. The reason for their relevance is that people often perceive unprecedented times as having associated unprecedented risk, and so this pessimistic future outlook of the economy causes some investors and traders to focus on holding onto their money as tightly as possible, rather than seizing better opportunities within the market. Hoping to shed some light upon many of the intuitive misconceptions associated with the so- called ‘alchemy’ of those who can prosper during the harshest of market conditions, this article will endeavour to discuss the importance of risk sentiment knowledge through the lens of the foreign exchange market.
So what is risk sentiment?
Risk sentiment is essentially the appetite of investors or traders whether or not to take on assets that are perceived to be risky. Sentiment is subjective and so it describes a perception by each individual about the future economic outlook based upon current data, be that positive or negative. Therefore by extension, risk sentiment also describes investors or traders’ behaviour in response to this appetite.
Risk sentiment is often classified into two paradigms, as either being ‘risk-on’ or ‘risk-off’.
Risk-off sentiment details a risk aversion among investors or traders, due to an uncertain economic outlook. This may be the case due to a recent fall in economic output, GDP, corporate earnings, the equity market, a rise in the VIX or widespread job losses. Due to globalisation and the intertwined nature of the markets presently, it isn’t uncommon for markets to experience a domino effect due to their systemic risk, with one or more industries’ turmoil affecting that of another’s. Perceived contracting economic data moves investors and traders to transfer their earnings to safe haven currencies such as CHF, JPY and more recently during Covid-19, USD. Portfolios will also look to offload high beta assets during this time. This sell-off of risk-on assets for their risk-off counterpart often comes very quickly due to the nature of mass psychology and can resemble that of an avalanche.
Alternatively, risk-on sentiment details a high risk tolerance among investors or traders due to a positive future economic outlook. This perception is usually due to a combination of factors, including high GDP, expansionary monetary and fiscal policy and a rise in corporate earnings. The economy in this case operates as a well-oiled machine, with all parts moving in tandem to create optimal economic output. Portfolios will also usually hold high beta assets due to the higher potential returns and the low perceived likelihood of incurring a loss. In this case, money flows out of the safe- havens and into ‘riskier’ currencies such as GBP, NZD and EM currencies, which are now perceived to be able to be bought at discount rates, having weakened from past economic turmoil and previous ‘risk-off’ market sentiment. Notably, risk sentiment operates in cycles and so therefore the ability to identify market sentiment at each moment is a vital addition to any investor or trader’s artillery.
One barometer to gauge risk sentiment in the market is the VIX Volatility Index, colloquially referred to as the ‘fear index’. This index represents the S&P 500 options market which prices in expected future changes in Put and Call option strike prices. To summarise, rallies in this index indicate a pessimistic future economic outlook, which means increased perceived market risk and therefore a ‘risk-off’ sentiment in the market. Investors and traders will therefore look to move their investments to safer, more secure assets which hold their intrinsic value. The corollary also applies, with dips in the VIX leading to investors and traders having a higher risk tolerance due to perceived low market risk and therefore money flows out of the safe havens.
So how can this knowledge of risk sentiment increase our individual investing or trading
The reason is that risk sentiment acts as a crucial bias for investors and traders to understand which currencies will ultimately strengthen or weaken in the short-to-medium run, despite minor periods of correction and consolidation in the interim. Since trending markets move in impulses and corrections, and in order for markets to trend the impulse must be larger than the correction, it makes sense to endeavour to trade the impulse rather than the correction due to its higher probability of a successful outcome and its higher risk-to-reward ratio. Therefore, knowing the overall direction and trend, which can be given by risk sentiment is pivotal to giving investors and traders an edge upon which they can capitalise on higher probability set-ups in the market.
So what defines a currency’s risk?
‘Risk-off’ safe haven currencies retain their value and strengthen during times of market instability, due to them being linked to a commodity (such as gold in the Swiss franc’s case), representing a powerful global economy (such as Japan in the Yen’s case), having a somewhat negative correlation with the equity market or a combination of all three. Therefore in times of risk-off market sentiment, rallies in EM currencies should be sold while dips in safe haven currencies should be bought.
The corollary also applies for ‘risk-on’ currencies. These currencies are often linked to smaller, more unstable economies, which are not backed by commodities and have a somewhat positive correlation with the equity market. Dips in EM currencies should alternatively be bought in ‘risk-on’ markets with rallies in safe havens being sold.
It’s important to note however that in each market scenario there will always be assets that prosper and assets that fail due to the unlimited number of unforeseen factors and variables that can affect an asset’s price, despite market conditions. Nevertheless, I would argue that these represent the outliers and not the majority. Knowing that investing and trading is a game of probabilities, in which you don’t know the outcome of each individual decision and only that of the overall long-term outcome in accordance with a pre-defined strategy, I would argue that understanding the overall direction of trending markets and shaping your investment or trading philosophy to align with that understanding, gives each individual investor or trader the greatest probability of long-term market success and an increased risk-to-reward ratio.
Finally, returning to Buffett’s seminal mantra, a holistic understanding of risk sentiment and the ability to identify trending markets allows investors and traders to effectively limit risk exposure through methods such as hedging, capital re-allocation and bias switches. Limiting downside exposure inadvertently increases the risk-to-reward ratios of each investing or trading decision and it is this increased risk-to-reward, coupled with an increased win rate through higher probability decisions, which leads to success and prosperity in the market.
By Edward Collins - BSc Economics and Finance, University College Dublin
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