If there’s one thing investors have become accustomed to in the post global financial crisis world, it’s the prevalence of risk-on risk-off (RORO) behaviour across broader asset classes.
Whether due to the introduction of increasingly creative monetary policy settings from major central banks such as the US Federal Reserve, European Central Bank and Bank of Japan, or the increased involvement of algorithmic trading in many asset markets, it just seems that some assets — no matter what the underlying fundamentals — tend to rise when sentiment is strong and fall when sentiment is poor.
According to Daniel Fenn, Mark McDonald and David Bloom of HSBC, RORO is simply the lumping together of certain asset classes — despite individual characteristics — as being either risky or safe haven assets.
“The hallmark of the RORO phenomenon is that assets lose much of their individual character and, instead, split into two camps,” wrote the trio in a research note released in late April.
“They are either risk-on (“risky” assets) or risk-off (“safe havens”). In this bipolar world, returns from different assets are increasingly related, with either strong positive or strong negative correlations between them. Furthermore, these cross-asset correlations are not just high, but stable.”
After a few years where RORO lost some of its potency, most likely due to the US Federal Reserve priming markets for the likelihood of higher US interest rates over the course of 2015, Fenn, McDonald and Bloom, believe that RORO has returned given the highly correlated performance of asset classes since the beginning of the year.
Risk on – risk off (RORO) is back. In the years since the 2008 financial crisis, markets have been dominated by global forces, with local differences playing a secondary role. RORO was the most notable of these, with its impact peaking between 2010 and 2013. As QE became an increasingly important driver of markets, RORO’s influence started to wane. However, this shift has reversed in 2016: At the start of the year, concerns over the Fed hiking cycle, falling oil prices, and Chinese growth led to a big risk-off move. As these worries have receded, markets have flipped to risk-on. RORO has returned. Risk on – risk off is once again the single most important driver of markets.
One doesn’t have to look hard, nor long, to see the reemergence of RORO at work.
Take today’s sleepy session in Asia, as a prime example.
Crude oil futures are pushing higher, the Australian dollar is stronger, the Japanese yen is weaker and stocks across the region are flat to higher.
It’s risk on in Asia — something of a feature on days when there is a relative dearth of major market-moving events.
As an important part of financial markets jigsaw puzzle, HSBC’s FX strategy team believe that currency markets are not immune to RORO behaviour, noting that many high-yielding and emerging market currencies have a strong relationship with shifts in investor sentiment.
The chart below, supplied by the bank, shows the correlation of several currency pairs to what it calls the “RORO factor”.
Based on analysis from HSBC, the Mexican peso, shown as its currency code of MXN, has the greatest correlation with RORO, tending to rise when sentiment is bullish and decline when sentiment is weak.
Other commodity-linked currencies such as the Russian rouble, Canadian dollar and Australian dollar also feature in the top four in this chart, something that will surprise few given their movements to those in crude oil seen over the past few months.
At the other end of the spectrum, HSBC note that the euro and Japanese yen tend to decline when sentiment is strong and rally when sentiment is weak, something that is likely due to these currencies being favoured by investors to fund carry trades, using ultra-low borrowing costs to fund investments in higher yielding asset classes.
With RORO now back in vogue, HSBC believe that there are two options for investors — directly position for risk on, risk off behaviour or mitigate its effects by eliminating it from the equation.
“Perhaps the cleanest way to invest in FX when RORO has returned is to simply trade risk directly,” say HSBC.
“If you have a strong conviction that risk on sentiment will prevail, then the best way to express this should be to buy those currencies with the strongest correlations to RORO. At this point in time, this would mean buying the MXN, RUB, AUD, COP, and CAD.”
While these currencies tend to be higher-yielding, HSBC notes that this strategy is “inherently risky in an environment where sentiment can change on the back of a single headline or data point”.
“In markets which have been experiencing thinning liquidity and higher correlations, trading in this way would likely be extremely volatile and could open an investor up to significant downside if the underlying trend moves against them,” they say.
For those investors who want to avoid the potential for being caught on the wrong side of RORO trade, HSBC believes investors should try to remove the RORO from the equation.
“This would mean avoiding pairs with the strongest correlations to RORO and expressing a view based on local factors amongst currencies with low correlations to RORO,” they note. “Returns are likely to be smaller, but should come with less volatility and less external risk.”
For those looking for currency pairs that are less exposed to the effects of RORO, the chart below, supplied by HSBC, shows those currency pairs with low correlations to risk-on, risk off behavior.
Some of the non-RORO trades the bank likes at present includes selling the Australian dollar against the Canadian dollar and selling the New Zealand dollar against the Norwegian krone.