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What is Risk-On and Risk-Off in Currency Markets?

Fundamental Analysis Course
In the world of global finance, traders and investors often classify market sentiment into two primary phases: Risk-On and Risk-Off. These phases represent the prevailing attitude towards risk, which in turn influences the movement of currencies. Understanding these phases and their impact on different currencies is crucial for navigating the foreign exchange (Forex) market.

Risk-On: Optimism and Higher Appetite for Risk

Risk-On refers to a period when investors are more optimistic about the global economy and stock markets. During such times, traders are willing to take on higher levels of risk in pursuit of greater returns. As the stock market experiences upward momentum, traders typically shift their investments away from safer assets like government bonds into riskier assets such as equities and commodities. This shift is known as Risk-On.

Why does this happen?

When the market sentiment is bullish and economic conditions appear favorable, investors are more inclined to borrow money at low interest rates and invest in higher-risk, higher-return assets like stocks. As a result, demand for riskier currencies, which tend to be correlated with commodities or emerging markets, rises. These currencies typically include the Australian Dollar (AUD), New Zealand Dollar (NZD), and Canadian Dollar (CAD).
Risk on / risk off gauge from the EdgeFinder

currency movements in risk-on:

During periods of Risk-On, USD, JPY, and CHF often experience weakness. These currencies are considered safe-haven assets, meaning they generally perform better when markets are uncertain and investors seek safety. In contrast, riskier assets like the AUD, NZD, and CAD tend to appreciate in value due to increased demand for commodities like oil, iron ore, and agriculture.

Bullish Currencies:

AUD (Australia is a major exporter of commodities like iron ore and copper)
NZD (New Zealand is a major exporter of agriculture, machinery, and mining products)
CAD (Canada is a key oil exporter)
GBP (The British Pound may rise due to optimism about the UK economy)
EUR (The Eurozone often benefits from an overall positive market sentiment)

Bearish Currencies:

USD (The value of the US Dollar may decline as investors look to higher-yielding assets)
JPY (The Japanese Yen is typically weaker in a Risk-On environment due to low interest rates and the country’s weak economic growth)
CHF (The Swiss Franc can weaken due to reduced demand for safe-haven assets)

Risk-Off: Pessimism and the Flight to Safety

The Risk-Off phase occurs when investors become more cautious and seek to reduce exposure to risky assets. This often happens during times of global uncertainty, market declines, or geopolitical instability. As the stock market drops, investors flock to safer investments, such as government bonds or safe-haven currencies like the US Dollar (USD), Japanese Yen (JPY), and Swiss Franc (CHF). This is a clear indication that traders’ risk appetite has significantly reduced, and they are seeking stability and security in uncertain times.

Why does this happen?

When markets experience turbulence or a negative outlook, traders move capital from riskier assets like equities and commodities into safe-haven currencies. These currencies have a history of retaining value during economic downturns or periods of financial instability. The demand for these currencies increases, while demand for higher-risk currencies like the AUD, NZD, and CAD tends to decrease.

currency movements in risk-off:

During periods of Risk-Off, the USD, JPY, and CHF tend to perform better due to their status as safe-haven assets. As investors liquidate their positions in equities or commodities, they often convert their funds into these currencies, driving up their value. On the other hand, currencies tied to commodities, such as the AUD, NZD, and CAD, generally experience a decline as demand for these assets wanes.

bullish Currencies:

USD (As a global reserve currency, the US Dollar tends to appreciate in times of uncertainty)
JPY (Despite Japan's high debt-to-GDP ratio, the Yen tends to strengthen as investors seek safety)
CHF (The Swiss Franc, though subject to intervention by the Swiss National Bank, is often sought during times of market stress)

bearish Currencies:

AUD (Australia’s economy is heavily reliant on commodity exports, which tend to decline in a Risk-Off environment)
NZD (Similar to the AUD, the New Zealand Dollar falls when global risk appetite diminishes)
CAD (Canada’s economy is closely tied to oil prices, which are sensitive to global economic conditions)
GBP (The British Pound can struggle in uncertain global environments)
EUR (The Euro often faces pressure in times of pessimism, especially given economic challenges in the Eurozone)

The Role of Commodities in Risk-On and Risk-Off

The currencies of countries that are major exporters of commodities often reflect the broader global sentiment. In times of Risk-On, the increased demand for commodities boosts the value of currencies like the AUD, NZD, and CAD. Conversely, during Risk-Off periods, the decline in commodity demand causes these currencies to weaken.

- AUD: Major exporter of iron ore and copper, which tend to see higher demand when global markets are optimistic.
- NZD: A leading exporter of agriculture products, machinery, and mining resources, often benefiting from global growth.
- CAD: Highly correlated with the price of oil, Canada’s currency tends to rise when oil prices increase during periods of economic expansion.

Safe-Haven Currencies: JPY and CHF

Although JPY and CHF are traditionally considered safe-haven currencies, they have unique characteristics that can make them more complex to understand.

JPY: Despite Japan’s high debt-to-GDP ratio and prolonged low-interest rates (including negative rates in 2016), the Yen tends to strengthen during Risk-Off phases. This is because Japan's current account surplus and its status as a creditor nation make the Yen an attractive currency for investors seeking safety.

CHF: The Swiss Franc is considered a traditional safe haven, even though the Swiss National Bank (SNB) has intervened in the past to prevent the Franc from becoming too strong. The Franc benefits from Switzerland’s stable political and economic environment.

Conclusion

Understanding Risk-On and Risk-Off sentiment is crucial for forex traders. During Risk-On, optimism drives demand for riskier currencies, such as the AUD, NZD, and CAD, while safe-haven currencies like the USD, JPY, and CHF typically weaken. In contrast, during Risk-Off, investors flock to the safety of the USD, JPY, and CHF, while riskier currencies decline in value.

By recognizing these trends and understanding the underlying economic factors that drive them, traders can better navigate the forex market and make informed decisions based on global sentiment.

Key Takeaways

Risk-On occurs when investors are optimistic, driving demand for riskier currencies like the AUD, NZD, and CAD.
In Risk-Off periods, investors seek safety, leading to a rise in demand for safe-haven currencies such as the USD, JPY, and CHF.
Commodity-linked currencies like the AUD, NZD, and CAD tend to perform better during Risk-On and weaken during Risk-Off.
Safe-haven currencies like the JPY and CHF tend to appreciate during periods of market uncertainty, despite Japan’s high debt and Switzerland’s interventions.
Understanding Risk-On and Risk-Off sentiment is crucial for forex traders to anticipate currency movements based on global economic conditions.

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Leveraged trading in foreign currency contracts or other off-exchange products on margin carries a high level of risk and is not suitable for everyone. You may lose more than you invest. Price and performance data is provided for informational purposes only and is not investment advice. Past performance is not indicative of future results.

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