Ultimate Guide to Understanding and Trading Risk Sentiment
After receiving numerous questions from our subscribers about risk tones and risk sentiment, we’ve decided to dive deeper into this crucial topic. In this comprehensive guide, we will cover three main points: what risk sentiment is, how to identify it, and how to trade it effectively.
What is Risk Sentiment?
Risk sentiment essentially refers to the mood of the market, specifically regarding traders’ appetite for risk. The market is driven by traders, who are emotional beings.
When traders are uncertain and fearful, this is known as “risk-off” sentiment, leading them to rotate away from riskier assets toward safer ones.
Conversely, when traders are feeling optimistic and greedy, thinking the market is in a positive state, this is called “risk-on” sentiment, prompting them to move towards riskier assets and away from safer ones.
Identifying Risk Sentiment
To evaluate risk sentiment accurately, it’s essential to consider various asset classes, not just currencies or equities in isolation. Here’s a detailed breakdown of how different asset classes respond to changes in risk sentiment:
Equities
Equities are considered one of the riskiest assets due to their high volatility and quick reactions to changes in risk appetite.
A strong risk-on tone typically results in global equity strength, while a risk-off tone leads to global equity weakness. However, it’s important to consider individual factors affecting equities, such as stock performances, earnings releases, and country-specific issues.
Commodities
Commodities, like oil and copper, are considered risky assets due to their high volatility. In a risk-on environment, these commodities tend to perform well, while in a risk-off environment, they generally perform poorly.
Gold, however, is a safe haven commodity. It moves inversely to risk sentiment: rising in a risk-off environment and falling in a risk-on environment. It’s crucial to also consider supply and demand factors, as well as other influences like interest rates when evaluating commodities.
Government Bonds
Government bonds, particularly those with high ratings like US Treasury bills, are considered the safest investments. During economic uncertainty (risk-off sentiment), demand for these bonds increases, causing their prices to rise and yields to fall.
Conversely, in a risk-on environment, bond prices fall, and yields rise. Individual factors like interest rate expectations and quantitative easing also affect bond prices.
Volatility
The volatility of an asset’s price indicates perceived market risk. High volatility suggests high risk (risk-off sentiment), while low volatility suggests low risk (risk-on sentiment). The VIX index is a useful tool for gauging equity market volatility. Generally, a VIX below 15 indicates low risk, while a VIX above 18 indicates high risk.
Currencies
Forex traders often capitalize on risk sentiment by trading risk-sensitive currencies. High beta currencies, such as the Australian dollar (AUD), New Zealand dollar (NZD), and Canadian dollar (CAD), are more volatile and sensitive to risk appetite changes.
Safe haven currencies, such as the Swiss franc (CHF), Japanese yen (JPY), and US dollar (USD), are perceived as safer during times of uncertainty. In a risk-on environment, high beta currencies strengthen, and safe havens weaken. In a risk-off environment, the opposite occurs.
Trading Risk Sentiment
The goal in forex trading is to pair a strong currency against a weak one for the best trading opportunities. Here are two examples:
Risk-On Environment
In a risk-on environment, high beta currencies (AUD, NZD, CAD) are supported, while safe havens (JPY, CHF) are pressured. A good trade would be to buy AUD/JPY.
Risk-Off Environment
In a risk-off environment, safe havens (JPY, CHF, USD) are supported, while high betas (AUD, NZD, CAD) are pressured. A good trade would be to sell AUD/JPY.
Additional Considerations
- Alignment with Other Factors: The best trading opportunities arise when risk sentiment aligns with other short-term drivers. For instance, if the Reserve Bank of Australia is expected to cut interest rates due to poor economic data, this would weaken the AUD. If this aligns with a risk-off sentiment, selling AUD against a safe haven currency like JPY becomes a strong trade.
- Interconnected Asset Classes: Remember that asset classes are interconnected. Multiple asset classes indicating the same risk sentiment strengthen the signal.
- Imperfection of Correlations: Correlations aren’t perfect. Other factors can influence currencies, equities, commodities, and bonds, so be aware of these nuances.
- Short-Term Nature: Risk sentiment is often driven by emotions and can change quickly. These trades are usually short-term and should be acted upon swiftly.
- Understanding the ‘Why’: Knowing why the market is in a risk-on or risk-off sentiment helps determine how to trade it. High conviction trades are usually driven by significant catalysts like economic data releases, geopolitical events, or major policy announcements.
The Impact of Economic Data Releases on Risk Sentiment
Economic data releases play a significant role in influencing risk sentiment throughout the day. These releases can create substantial market movement in three stages:
Anticipation of the Release
Before the release of key economic data, markets often enter a state of anticipation. Traders and investors make speculative moves based on expected outcomes.
This can lead to increased volatility as market participants position themselves for potential outcomes. For instance, if a positive jobs report is anticipated, risk-on sentiment may strengthen as traders expect improved economic conditions.
Post-Reaction to the Release
Once the economic data is released, the market reacts swiftly to the actual figures. If the data meets or exceeds expectations, risk-on sentiment can surge, leading to a rally in riskier assets like equities and high beta currencies.
Conversely, if the data falls short of expectations, risk-off sentiment may dominate, driving investors toward safer assets like bonds and safe haven currencies.
Key Data Points That Move the Market
Certain economic data points are particularly influential in shaping risk sentiment. These include:
- Non-Farm Payrolls (NFP): The monthly NFP report is a crucial indicator of US employment health. Strong job growth signals economic strength, boosting risk-on sentiment, while weak job growth can trigger risk-off sentiment.
- Gross Domestic Product (GDP): GDP growth rates provide insight into the overall health of an economy. Higher-than-expected GDP growth fosters risk-on sentiment, whereas lower growth can prompt risk-off moves.
- Inflation Reports (CPI, PPI): Inflation data affects central bank policies and interest rates. Higher inflation can lead to expectations of rate hikes, influencing risk sentiment accordingly.
- Central Bank Meetings and Announcements: Decisions and statements from central banks like the Federal Reserve or the European Central Bank can significantly impact risk sentiment. Hawkish tones may boost risk-on sentiment, while dovish tones can enhance risk-off sentiment.
For a comprehensive view of upcoming economic data releases and tools to trade them, be sure to check our Economic Calendar.
Conclusion
This ultimate guide to risk sentiment aims to clarify this complex topic and provide practical advice on identifying and trading it. Understanding the role of economic data releases can further enhance your ability to navigate market sentiment. For how to trade risk events, visit our Professional Economic Calendar.