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We’ll be explaining how the concept of risk on / risk off is basically just the market switching its mood from excited and bullish to fearful and conservative. And back and forth.
We’ll also be explaining why the Japanese Yen and the Swiss Franc are generally the two best currencies to trade when the markets are switching between those moods.
Now, if you follow financial news, you’ve probably heard the term ‘risk on and risk off’. But what exactly does that mean, and how can you make money from it? Well, let’s begin with the phrase ‘risk off’. This essentially means that the market is afraid and fearful.
The number one reason the market will turn to a risk off environment is when they can’t figure out what will happen next. This is often known as uncertainty. And the markets HATE uncertainty more than any other single thing. Because they are uncertain, the market tends to just play everything very safe. This means that they buy assets that a traditionally viewed as safe and stable.
This includes things like gold and government bonds. And currency traders almost always turn to Swiss Franc and the Japanese Yen.
The reason that these two currencies are considered so safe involves a number of factors. For example, the Yen is seen as secure because Japan is known as a creditor nation. This means that the world owes Japan more than Japan owes to the world. This puts it in a strong position economically if everyone is calling their debts in, as happens during a financial crisis.
Meanwhile, Switzerland has built a reputation of financial stability and trust during even the worst global crashes. The economy of Switzerland remained secure even during two world wars, which were being fought right on its door step. Nations on all sides of the conflict trusted the Swiss banks to store their wealth securely.
During times of risk off sentiment, the Japanese yen is definitely the most popular currency. This is usually the biggest mover when markets start to seek out shelter from economic storms.
Eventually those storms pass and the market becomes more confident and optimistic in the overall picture. This leads to a risk on environment emerging. When markets are risk on, they typically feel comfortable chasing higher returns which of course involve taking more risk.
They tend to invest in assets that traditionally deliver those returns. This includes things like the stock market and corporate bonds. Currency traders look to higher yielding currencies. This normally includes commodity-based currencies such as the New Zealand and Australian dollars.
For example, Australia relies heavily on selling its materials to economies that are building and expanding, such as China. This means that during the good times the economy will surge ahead and growth with be rapid. This will naturally encourage higher interest rates as the central bank battles to control it. This higher rate gives traders a much better return.
The risk comes from the fact that if there is an economic slowdown in other countries this can directly result in a slowdown in Australia. In this way, the Australian economy is at the mercy of the global picture and unable to be fully in control of its own destiny.
Interest rates fluctuate over the years so as a general guide you should buy currencies that have a current account surplus with the rest of the world, during Risk off environments (Like the Japanese Yen). When the markets turn risk on it’s best to buy the currencies that have commodity-based economies and, if possible, the highest interest rates, comparatively.