The fluctuation between risk appetite, also known as “risk on”, and risk aversion, dubbed “risk off”, is a daily changing sentiment on the market.
Difficult as it may seem to get insight into risk sentiment, it is a simple matter compared to tracking the stock market trend. Every day, a new rumor starts circulating, and there is a corresponding shift on stock markets. The daily fluctuations generate risk sentiment which can amount to a heavy toll on investors. One simple way of getting insight into underlying trends is by judging investors’ risk appetite. By becoming aware of market sentiment direction, traders can adjust their trading in line with it.
When there is a sizable increase on the stock market, that is an indication of prevailing risk appetite. In this risk on mood investors have positive expectations about the economy, so they put their capital on the stock exchange and bet on high yielding currencies. As a result, stock market valuations rise and risk currencies, such as the Australian dollar and the New Zealand dollar, rally.
With low yielding instruments gains are smaller and even losses can occur. The selling of currencies offering low interest rates is done as a means to finance the purchase of higher yielding ones. That process is termed “carry trade” and is discussed in our article “Two concepts you must know: Rollover and Carry trade”.
When investors experience risk aversion, they avoid risky instruments. In such situations they withdraw their money from shares and high-yield currencies. With a risk off market sentiment in place, there is no favorable ground for carry trade. Risk currencies are still offering positive overnight swaps, of course, but unfavorable exchange rate movements offset any interest gains. In a risk aversion setting, the safer choice for traders is the purchase of safe currencies. Examples of these are the US dollar and the Japanese yen.
There was one more safe currency until recently: the Swiss Franc. However, the Swiss National Bank intervened in August 2011, in an effort to limit the buying of CHF, which was dealing a heavy blow to the Swiss economy. Since its last major intervention, the SNB has promised to keep 1.20 for EUR/CHF as the highest level the Swiss franc would be allowed to reach against the euro.