Risk appetite


Risk-on Risk-off Indicators

Risk aversion refers to when traders unload their positions in higher-yielding assets and move their funds in favor of safe-haven currencies. This normally happens in times of uncertainty and high volatility, a so-called “risk-off” environment. In turn, periods of perceived low financial risk encourage investors to take risk, therefore creating a “risk-on” situation. The following instruments are excellent barometers of market sentiment that can indicate higher or lower risk taking depending on their performance.

VIXY: PROSHARES VIX SHORT-TERM FUTURE

VIXY Down = Risk-On  

VIXY Up = Risk-Off

VIXY seeks to track the performance of the S&P 500 VIX Short-Term Futures Index. The VIX, inferred from the prices of option on the stock exchange and known colloquially as the "fear index," is a widely-used proxy for global risk aversion and for markets' sensitivity to uncertainty.

Note that there can be differences between the actual movements of the VIX and the movements of VIX futures contracts. But as a general rule, when the VIX climbs, risk aversion is enveloping global markets.

Gold / Silver Ratio

Ratio Down = Risk-On  

Ratio Up = Risk-Off

A contracting economy usually decreases the industrial demand for silver while gold tends to keep its value as a monetary asset. The reason is that silver functions mainly as an industrial metal while gold serves as a hedge against economic and political uncertainty. As a result, this ratio normally goes up during risk aversion and falls off during times of risk appetite. A rising ratio means gold is outperforming silver, and a falling ratio means silver is favoured. When this ratio is about to turn from a bottom, traders expect risky assets to fall. When silver out-muscles gold and the ratio starts to slip, the market's appetite for risk grows.

VANGUARD TOTAL BOND MARKET (BND)

BND Down = Risk-On  

BND Up = Risk-Off

At the moment, U.S. Government Treasuries is one of the safe havens of choice. As an investment they don't pay much interest, but they are considered a safe place to park money. When the return of principal is more important that the return on investment, the priority becomes finding a place to park big capital flows. And U.S. Treasuries are considered the ultimate safe haven for that. Should conditions change, the money will fly off to other locations perceived to be safer. A rising line implies nervousness about the global economy and suggests rising risk aversion, while a price deterioration emphasises a generally optimistic market place.

DOW JONES UTILITIES

Utilities Down = Risk-On  

Utilities Up = Risk-Off

The Dow Jones Utilities Average comprises 15 utility stocks drawn from electric, gas pipelines, telephone companies, and so forth. A rise in utility stock prices indicates investors are anticipating falling interest rates. That's because utilities are big borrowers and their profits are enhanced by lower interest costs. Conversely, the utility average tends to decline when investors expect rising interest rates. Because of this interest-rate sensitivity, utilities tend to outperform in period of pessimism and deflationary expectations, and severely underperform during periods of overconfidence and bravado.

PowerShares S&P 500 High Beta Portfolio (SPHB) vs. PowerShares S&P 500 Low Volatility Portfolio (SPLV)

SPLV UNDERPERFORMING SPHB = Risk-On  

SPLV OUTPERFORMING SPHB = Risk-Off

This study compares high beta and low volatility stocks. The SPHB ETF consists of 100 stocks within the SP 500 with the highest sensitivity to market movements over the last 12 months, and the the large-cap oriented SPLV, on the other hand, is devoted to 100 of the lowest volatility stocks. Constructed in a similar fashion, each constituent in the SPHB is given an equal share of assets. The first includes mainly discretionary, financials, and technology companies, and the second reflects a more conservative investing style with large allocations to utilities, financials, and consumer staples. During defensive days, when investors accumulate in low volatility areas, the SPLV would typically take over as the dominant percentage gainer. When risk taking resumes the SPHB usually leads the way.

NZD/JPY: New Zealand dollar vs. Japanese yen

NZD/JPY Up = Risk-On  

NZD/JPY Down = Risk-Off

The yen gives us some insight into risk appetite rising when investors do not want to deal with risk. The problem with using the USD/JPY cross is that it is subject to the overall strength and weakness in the dollar. Even if risk appetite stays the same, if the dollar is strengthening or weakening, USD/JPY will change. Instead we can look at the NZD as a high yielding currency serving as a proxy for high yielding instruments. New Zealand and Japan have a large central bank benchmark interest rate differential, making it a popular carry trade. Therefore, the NZD/JPY pair tends to decline when risk aversion permeates the markets, and rise when the market is turning risk unfriendly.

NASDAQ 100

NASDAQ Up = Risk-On  

NASDAQ Down = Risk-Off

When money is chasing return and market mood is improving, capital tends to favor equities. As a general rule, the NASDAQ -flush with technology stocks- tends to imply retail money, while the S&P 500 tends to reflect institutional investment and the Dow Jones international big money. The allure of what is popular is hard to resist. That is why when you see the NASDAQ falling it is labeled as “risk-on”. Alternatively, once the fear of losing subsides the NASDAQ tends to outperform, as tech stocks may get irrationally sold.

Dow Transportation Average

DJIA Up = Risk-On  

DJIA Down = Risk-Off

Dow Jones Transportation Average is a U.S. stock market index of the transportation sector. The central idea behind the Transportation Average as leading the other Dow averages was that if underlying businesses are going to do well, the prospects for the Transportation providers had to be strong. There are now many service oriented companies included in the Industrials Average that may perhaps prosper without a similar rise in the Transportation companies, but the broad idea that the Transportation Average and the Industrial Average are interlinked will remain at the center of Dow Theory.

COPX: GLOBAL X COPPER MINERS ETF

COPX Up = Risk-On  

COPX Down = Risk-Off

Copper is a barometer of economic health. It's the world's third most widely used metal, after iron and aluminum, and is primarily used in highly cyclical industries such as construction and industrial machinery manufacturing. Copper is then considered a coincident indicator for bond prices and utilities which tend to fall when copper rises. A rise in copper prices invites risk-on flows and shows that markets are turning to riskier assets. Falling copper prices, on the other hand, implies economic weakness forcing cash into safe havens.

DBB: POWERSHARES DB BASE METALS FUTURE

DBB Up = Risk-On  

DBB Down = Risk-Off

Industrial metals like aluminum and copper are especially sensitive to economic trends because they have a myriad of industrial applications apart from being used in the building of autos and homes. For this reason, normal intermarket relationships dictate that industrial metals usually have a much closer correlation to bond prices than other commodities that are more weather-related or prone to supply shocks. Base metals rise on the back of rising risk appetite, and fall with expectations of weaker economic conditions.

HYG: ISHARES IBOXX USD HIGH YIELD CORPORATE BOND

HYG Up = Risk-On  

HYG Down = Risk-Off

Another way to gauge the extent of market risk-taking is looking at junk and corporate bonds. At times of economic uncertainty and higher probability of default, yields are pushed higher to compensate for the risk of default, and so the price of those bonds decreases (remember yield and price go opposite), suggesting rising risk aversion. The alternate scenario, when investors accumulate confidence in purchasing higher-yielding and therefore riskier- assets, the intensified risk appetite manifests in rising high-yield bond prices.

EEMO: POWERSHARES S&P EMERGING MARKETS

EEMO Up = Risk-On  

EEMO Down = Risk-Off

Emerging markets are synonymous to higher growth and higher yield. However, all high returns must be judged within a risk framework: this can be political risk, bankruptcy risk, less liquidity, and foreign exchange rate risks, among others to be considered when trading EM assets. Countries which offer high yields, such as Brazil, South Africa, and Turkey, are poised to benefit the most by any risk-on flows, but they are also more susceptible to global monetary tightening than are developed markets. As such, these markets display a strong positive correlation with risk.

FAANGs

FAANGS Up = Risk-On  

FAANGS Down = Risk-Off

FAANG is an acronym for the five most popular and best performing tech stocks in the market, namely Facebook, Apple, Amazon, Netflix, and Alphabet’s Google. The massive combined market capitalization of the FANG stocks is explains their dominance in several benchmark indices. Gains in these stocks are attributed to investor's continued appetite for risk. When people are buying growth stocks such as the FAANG group instead of value stocks which are associated with economic strengthening, the market is considered to be growing roses. Conversely, a burst in animal spirits is usually reflected in high-flying FANG technology stocks turning South.

SCHWAB FUNDAMENTAL SMALL CAP (FNDA) vs SCHWAB US LARGE-CAP (SCHX)

FNDA outperforming SCHX = Risk-On  

FNDA underperforming SCHX = Risk-Off

The FNDA index measures the performance of the small company size segment by fundamental overall company scores, which are created using companies included in the Russell 3000. The SCHX, on the other hand, seeks to track as closely as possible, the total return of the large capitalization companies included in the Dow Jones U.S. Large-Cap Total Stock Market Index. Small caps, being more volatile, are easier to move, reason why they tend to outperform large caps in periods of rising confidence and drastically underperform during corrections.

FIDELITY CONSUMER DISCRETIONARY (FDIS) vs FIRST TRUST CONSUMER STAPLES (FXG)

FDIS outperforming FXG = Risk-On  

FDIS underperforming FXG = Risk-Off

Gyrations of the different sectors in the business cycle reflect distinct changes in the rate of growth in economic activity, as well as changes in the employment backdrop and monetary policy. When the stock market is in a process of discounting potential economic slowdown, for instance, staples tend to outperform as money chases recession-proof, dividend paying companies like tobacco and healthcare. Consumer discretionary stocks, in turn, depend on capital spending and consumer demand, and tend to outperform during periods of increased optimism.

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Impact on FX Markets

First and foremost, risk aversion can lead to liquidation and/or profit taking. The process of unwinding these trades may result in a need to buy back funding currencies like the U.S. Dollar and Japanese Yen. When the above charts convey a sense of nervousness in the markets, risk-sensitive currencies will be keept in demand.

A few years ago, in 2015, the ECB announced its massive QE program changing the dynamics of Euro trading. The quick enlargement of the ECB's balance sheet and the negative deposit rate sent money away from the euro-zone to find higher-yielding, riskier assets elsewhere. The Euro turned into a funding currency, not dissimilar from the Japanese yen. Nevertheless, this role as a safe haven currency did not last for too long. EUR/USD returned to a more normal behavior later that year. Now that the ECB has halved its bond-buying program, and it is on course to end these buys altogether, the brighter prospects for the euro area mean that it could attract riskier trades rather than safer ones. This means that in a risk off environment, money may flow into the yen, where the BOJ is not thinking of tightening, rather than into the euro.

In a serious risk-off environment one should see major shifts in the price of gold. Should gold do not appreciate, means that traders are not feeling the environment as dangerous. Likewise, in times of risk aversion we would expect the USD/JPY to fall lower. When that is not the case and USD/JPY holds up well, it suggests that there is less fear than market indicators show. 

During a risk-off event, dumping equities for bonds is another natural response. 

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