“In chaos theory, the butterfly effect is the sensitive dependence on initial conditions, where a small change at one place in a nonlinear system can result in large differences to a later state. The name of the effect, coined by Edward Lorenz, is derived from the theoretical example of a hurricane's formation being contingent on whether or not a distant butterfly had flapped its wings several weeks before.”

Have you ever heard market commentators talk about “Risk-On” and “Risk-Off” and wondered what they meant?

Risk-On means investors are feeling positive about the economy and markets and their appetite for risk goes up. Currency traders and speculators will flee the USD for currencies of countries that have higher yields, like the Canadian dollar, Aussie Dollar and even the Euro. The USD and Yen will typically fall in value. In addition stock markets around the world will rise in value.

Risk-On = Rising Stock Markets = Weak US dollar

Risk-Off means investors are feeling negative about the economy and markets and their appetite for risk goes down. Currency traders and speculators will flee higher yielding currencies and the USD and Yen will typically appreciate in value. In this scenario stock markets around the world will fall in value.

Risk-Off = Falling Stock Markets = Strong US dollar

Gold is a special circumstance. Traditionally when feelings became negative about the economy and markets, a Risk-Off environment, investors would turn to gold as a safe haven. More recently gold has been acting like a Risk-On asset.

Through stimulus and money printing, central banks around the world are trying to create, what feels like, a permanent Risk-On environment. All markets are interrelated and go through periods of time when they are highly co-related. To determine whether the market is going to be up or down, the first thing I look at is the strength of the US dollar first thing every morning. A strong US dollar usually suggests markets have sold off in Asia and Europe and North America will face a weak open.

Now that we have generally defined what “Risk-On” and “Risk-Off” are, the next logical question is to ask where are we now and what should we keep our eyes on?

Source: Yahoo Finance

The above chart demonstrates the relationship between a weak US dollar and Stronger Markets and vice versa.  For historical perspective my first chart is the chart of the AUD/USD, Australian dollar vs. The US dollar (the chart above).  More than any chart this chart shows the relationship between currencies and stock markets.  I have compared the price action of the AUD/USD to the price action of the Dow Jones Industrial average; the price action of the Dow is the red line.  In 2008, when stock markets around the world were taking a nose dive the Aussie dollar was taking a nose dive too.  Investors fled all asset classes and ironically moved to the relative safety of the USD.  The Australian dollar bottomed months before the market bottomed in 2009.  In deflationary times cash is king.  Cash is required to pay for bills.  At this moment in time, the USD also happens to be the reserve currency of the world.  Commodities like oil are paid for in US dollars.  If you look at charts of all currencies from that period of time, except for perhaps the Yen, all currencies fell in value against the USD.  If you look closely at the chart the price action of the Dow and the AUD/USD are very similar.  I wonder how long the USD will remain the reserve currency; I hear Iceland is thinking of adopting the Canadian Loonie!? 

Where are we now?  As a proxy for USD strength or weakness I have been watching the Euro closely.  The EUR/USD is the most heavily traded currency pair in the world and is the most heavily weighted component in the USD index.  As you may well be aware there are also a lot of problems in Europe.  With all the problems in Europe, I sometimes question why the Euro has not sold off, by sold off I mean crushed?  The answer most likely lies with the central bank.  Below is the chart of the EUR/USD.  Right now there is shelf under the 1.30 level of the EUR/USD.  The currency pair has approached this level 3 times in the past few months.  If this level holds, markets will most likely move sideways to upwards, and we will stay in a Risk-On environment.  If there is a prolonged break of the 1.30 level, stock markets will most likely be declining around the world and we will be in a Risk-Off environment.  I believe central bankers around the world are going to do everything in their power to keep us in a Risk-On environment.  Keep an eye on the 1.30 level in the EUR/USD.  Gold may be the best position to be in for both Risk-On and Risk-Off environments; remember fiat currencies are in a race to zero.  Gold producers are certainly showing good valuation right now.  Having said the above, if we enter a period of falling markets, it may be prudent to be long the US dollar and short US stocks to benefit from a decline in stock valuations and a rise in the US dollar.  Keep an eye on 1.30!

Source: Forex Pros

Is your portfolio positioned for Risk-On or Risk-Off environment?  

For ideas on how to position your portfolio for both environments and a complimentary review of your portfolio; 

Please don’t hesitate to give me a call or send me an email!  Edgar Burton 1.888.216.9779 ex. 402 or edgar.burton@europac.ca