Central bank policies have contributed to ‘risk on, risk off’ nature of FX – Goldman Sachs

A key driver of the ‘risk on, risk off’ nature of FX is central bank policy and monetary policy divergence, which is closely linked to growth (and inflation) differentials explains the research team of Goldman Sachs.

Key Quotes

“The ECB and BOJ have eased policy in recent years due weak growth and inflation, while the Fed has already started to tighten policy due to the better US recovery post the GFC. The correlation of the yen and euro with the VIX is closely linked to that of their respective 2-year rate differentials with the VIX. Both for euro area and Japan, the 2-year rate differentials with the US, which are a key driver of the FX, are positively correlated with the VIX.”

“In ‘risk off’ episodes, US 2-year rates have declined more than those in Japan and Europe as the market usually saw prospects for less Fed tightening (and recently also more limited easing options for the BOJ and ECB). Similarly, in ‘risk on’ episodes, the perception has been that the Fed is likely to tighten policy more than the BOJ and ECB as the US generally led in terms of growth. Due to weak growth (and inflation), both the BOJ and the ECB embarked upon new central bank policies such as more asset purchases and negative rates. As a result of those policies, the yen has traded more ‘risk-off’. The same has been true for Europe with the introduction of the ECB QE, but the euro has been more ‘risk on’ than suggested by the rate differentials due to political risks as discussed before.”

“Recent weaker US core CPI prints and signs of slowing growth might delay Fed tightening in the near term. And at the ECB’s June meeting, investors might get forward guidance on tapering in 2018. As a result, the EUR/US$ might stay stronger and with European growth more resilient than in the US equity/FX correlations could remain positive. Of course, too much ECB tightening or too much of a US slowdown could weigh on growth and equities eventually.”

Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these securities. You should do your own thorough research before making any investment decisions. FXStreet does not in any way guarantee that this information is free from mistakes, errors, or material misstatements. It also does not guarantee that this information is of a timely nature. Investing in Forex involves a great deal of risk, including the loss of all or a portion of your investment, as well as emotional distress. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility.