I used the terms risk-on and risk-off in a previous post, and someone was nice enough to comment that they had no idea what I was talking about. That’s always the downside of using trader jargon, but it’s pretty hard to talk about trading without it so the best alternative is simply for people to point out when I’m being unclear.
Risk-on and risk-off are really a way of describing very broad, medium term market movements. For the sake of simplicity, this thinking splits all financial assets in the world into two groups:
- Risk-on: these are assets that perform better if the economy is good than if the economy is bad. In other words, they are risky assets. Nearly all stocks, real estate and commodities fall in this bin. Risk-on assets also include any debt/bonds with a questionable rating – presumably if the economy is better it will be easier for a stressed firm to pay back their bonds either through profits or re-financing.
- Risk-off: these are assets that perform just as well regardless of the state of the economy, or even perform better when the economy is bad. Notably, these are the bonds of high credit rating countries like the US, Germany, Switzerland, Japan etc. Certain other assets can sometimes be risk-off: for example a partnership in a bankruptcy law firm. But the vast bulk of risk-off assets are government backed bonds.
Another way to think about this is that risk-on assets are where investors go to try to make money. Risk-off assets are where people go to protect money (high grade bonds have essentially zero default risk) while still earning a slightly greater than zero return. The single biggest factor in the movement of nearly all markets on a days to months timeframe is a sort of global herd movement from risk-on assets to risk-off or vice versa.
In order to see this global movement, it helps to do correlation analysis between the prices of various assets. Most people will be surprised at just how high the correlations are – for example the S&P 500 and WTI crude oil are about 80% correlated on a day time frame. When stocks go up, oil goes up. This is because both are risk-on assets – when the economy is good, companies will be more profitable and stocks are worth more. Likewise when the economy is good more oil will be consumed. Similarly when the economy sucks both oil consumption and corporate profits tank. Thus these two risk-on assets move mostly together.
The movement from risk-on to risk-off or vice versa is a sort of fear meter – it tells you what everyone believe is going to happen in the economy. When stocks are cheap and AAA bonds are expensive (aka near-zero yield) that means everyone’s afraid. When stocks are flying high and bonds are cheap (high yield) that means everyone’s an optimist.
Another aspect of risk-on/risk-off is its effects on currency prices. If you want to buy a Swiss bond, for example, you first need Swiss francs. Certain currencies, notably the dollar, yen and Swiss franc, are gateways to major pools of risk-off assets. Other currencies like the Brazilian real can only be used to buy risk-on assets. So when everyone gets afraid, you can expect the Swiss franc to appreciate against the real as the herd sells risky assets priced in reals, sells reals to buy francs, and then uses francs to buy Swiss bonds.
Risk-off dynamics can sometimes be altered by what exactly people are afraid of. For example during the PIIGS debt crisis (Greece round – we’re probably not done yet) the situation was complicated by the existence of the EU. Normally Germany and Switzerland are the benchmark bonds issuers for Europe. But Germany, as an EU member, was essentially attached at the hip to Greece – if Greece went down, so did Germany. As a result one of the typical safe-havens wasn’t really all that safe, and money instead fled just to the Swiss (producing record low yields) and out of Europe to the US and Japan.
Much of the movement you see in all financial markets (typically between 50-80%) can best be understood via the risk-on/risk-off dynamic.