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.
“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.”