by Cliff Wachtel, FX Empire
Understanding currency risk rankings & how to profit from them – even if you’re not a forex trader
Part 2B of our series on inter-market analysis. How the major currencies and pairs respond to market sentiment, why all types of traders or investors need to know it, and how anyone can use it for safer and higher returns. Enjoy.
Continued from Part A
Currency Correlations With Risk Sentiment: A Useful But Imperfect Tool
While the above risk ranking is useful for predicting how currencies should be moving at a given time, in reality currencies rarely perform exactly according to their risk ranking in strongly ‘risk on’ or ‘risk off’ periods on any given day. There are other drivers of forex trends besides risk appetite and these can and do dominate currency movements, especially in the short term.
A few examples of such influences include:
Currency specific news or longer term developments in that currency’s underlying economy can also alter these relationships. For example even on strong ‘risk' on days or longer periods, bad economic news about the Australian economy, or its chief trading partner, China, can cause the AUD to underperform other risk currencies. Economy-specific news and other short term developments are a major reason why currencies don’t perform in accordance with market sentiment in the short term.
Relative strength of a currency’s primary trading counterpart can also alter how a currency should behave based on its place on the risk spectrum. Currencies trade in pairs, so changes in currency pair prices always reflect changes in relative value. In some cases changes in demand for one currency can have dramatic effects on the other that have no direct connection to changes in risk appetite. For example, as we discussed in Part 1 of this series here, the EUR and USD virtually force each other to move in opposite directions because they are the most widely traded currencies and so purchases of one are so often funded by sales of the other. Thus if one is being heavily bought the other will tend to sell off regardless of normal drivers like risk appetite.
Central bank interventions can be a classic kind of event that alters how we’d expect a currency to behave relative to risk appetite. For example, during the summer of June 2011 when EU crisis anxiety was high and investors were flooding into the CHF, the Swiss central bank intervened to keep the CHF from rising beyond a certain rate in order to keep Swiss export prices down and competitive within the EU, Switzerland’s chief export market. The CHF plunged vs. the USD, EUR, and other currencies due to this intervention, not because of any big change in risk appetite.
Of course, in recent years central bank interventions (or speculation about them) have become, ahem, more than just outlier events. They are now an ever-present global market driver and are likely to remain so for years as until economies are healthy enough to prosper without them.
Central Bank Interventions As Primary Risk Sentiment Drivers
It’s no secret that central bank interventions have in fact BEEN a primary (if not THE primary) market sentiment driver. It certainly wasn’t improvements in the normal economic fundamentals that have driven most global stock markets in the developed world up near historic highs for most of 2013. Indeed we’ve had slow to flat growth or worse in employment, wages, and earnings.
Not only has the rally in stocks to historic highs lacked fundamental support, it has occurred under an exceptional number of recessionary threats. For example:
- The slowdown in the world’s one big growth engine, China
- The dormant but very much alive and unsolved EU debt and banking crisis
- Japan’s experiment with radical easing despite it’s already highest in the developed world debt/GDP and lack of any clear way to reduce it as its workforce and trade balance continue to shrink
The point is, in the current environment; don’t forget that central bank interventions have not been outlier events, but rather primary drivers of currency trends, both via their effects on interest rates and overall risk sentiment.
Seek The Underlying Drivers of Risk Appetite
That brings us to our concluding point.
While it’s very useful to know how to monitor risk appetite, (as we discuss in Part 3 of this series), and how to use currency pairs as another tool for hedging or profiting in times of changing risk sentiment, don’t forget what risk sentiment really is and where it comes from.
Remember that that risk sentiment doesn’t just create itself, it is usually just a shorthand description of the net effect of one or more underlying fundamental market drivers, regardless of whether we can accurately identify all of them.
Attempting to read risk sentiment and how currencies (or whatever your asset of choice) will react is useful, but it’s not a substitute for real fundamental analysis of what’s driving markets in your given time frame.
The Fastest, Easiest Way To Know What’s Driving The Markets
Unfortunately, that can be time consuming and complex.
Fortunately, there’s an easier way.
Just follow me. New to fxempire.com, I’ll be providing updates on what are prime forces moving most or all of the major global asset markets. Sometimes the updates will come daily, sometimes weekly. It all depends on what’s happening in the markets.
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DISCLOSURE/DISCLAIMER: The above is for informational purposes only and not intended to be specific trading advice. In other words if somehow you lose money based on the above I take no moral or legal responsibility for it. Deal with it.