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Understanding Risk-on Risk-off

The cycle of interest in risk aversion towards bonds and risk appetite towards stocks has its impact on the Forex market.

Risk-On vs Risk-Off

There are two fundamental types of investment – the bond market and the stock market. As bonds are guaranteed by national banks and governments, they are less risky than the stock market. So, when traders want to hunt for bigger wins, they need to seek areas of bigger risk. So, their risk appetite grows, and they transfer their interest from the safe bond market to the riskier stock market. This is RISK ON.

When there is fear in the stock market and stocks decline, money is transferred into the safer bond market for investment. The basic risk appetite of traders has significantly reduced, therefore this period of the cycle is known as RISK OFF.

RISK ON

Fund managers interested in investing in the stock market want to borrow money at cheap rates. If they borrowed the USD straight away, they would be missing the opportunity to borrow money at much lower interest rates. The three main currencies which are currently cheap to borrow are JPY, CHF, and EUR. These will be borrowed and sold on the Forex market in exchange for USD to then buy US stocks. So, the value of USD will rise, and JPY, CHF, and EUR will drop against the USD.

RISK OFF

Fund managers want to sell their investments in the stock market. Having sold, they then have USD which they need to sell in exchange for JPY, CHF, and EUR to pay off their original debt. So, during this period, the USD will drop, and the JPY, CHF, and EUR will rise.

What are Commodity Currencies?

During RISK ON there is more demand for these commodities so these currencies typically rise as there is optimism in the stock market. During RISK OFF, with pessimism in stocks, there will be less demand for these commodities so they will typically decline in value.

AUD: Major exporter to China of Iron and Copper
NZD: Major exporter of Agriculture, Machinery, and Mining
CAD: Major exporter of Oil
AUD
NZD
CAD

What are 'Safe Haven' Currencies?

Safe-haven currencies are those which tend to retain or increase their value during times of uncertainty and market instability. They tend not to have a correlation with the performances of stocks and bonds. They tend to have certain qualities: strong, liquidity, a stable political system, general economic growth, and stable finances.
The JPY is interesting as the Yen tends to soar during risk-off sentiment, although the country has the highest debt to GDP in the world and a weak financial situation. They have even had negative interest rates in 2016.
Also, the CHF is a safe haven, even though the Swiss National Bank has intervened to prevent the Franc from becoming too strong. The Norwegian Krone is sometimes seen as a safe haven, although many argue it lacks liquidity and is too correlated with commodity currencies.
USD
Gold
JPY
CHF
EUR

Risk On

Optimism in the Stock Market

Bullish
USD
AUD
NZD
CAD
Bearish
CHF
JPY
EUR
Gold

Risk Off

Pessimism in the Stock Market & need for safe-haven currencies

Bullish
USD
AUD
NZD
CAD
Bearish
CHF
JPY
EUR
Gold
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