Risk on-risk off trades have been all the rage in currency markets, but this strategist says the fiscal cliff may change that.
Ever since the financial crisis, currency markets have been more or less trading on the ups and downs in investors' risk appetite - also known as risk on-risk off, or RORO. David Bloom, global head of FX strategy at HSBC, thinks the pattern may not last.
The problem, Bloom says, is the fiscal cliff. Right now, the dollar is seen as the ultimate safe-haven currency, the go-to currency play when risk appetite is low. But even if the fiscal cliff - a wave of spending cuts and tax hikes due to be implemented at the end of the year - would tamp down risk appetite, it's hard to see how that would goose the greenback.
"In any rational world, a US-specific crisis would be bad news for the USD," Bloom wrote in a note to clients. "However, people are now wedded to the view that bad news = buy USD. The cognitive dissonance generated by the US-specific nature of the fiscal cliff is likely to lead people to simply buy the USD as usual – at least as a knee-jerk reaction. Clearly we think that this would a misguided reaction to the news."
That doesn't mean you should just sell the dollar as the fiscal cliff approaches, though.
Bloom points out that this "buy on bad news" approach can be powerful. When Standard & Poor's downgraded U.S. sovereign debt, the dollar actually rose.
"The US was downgraded because S&P felt that US debt was no longer of a high enough standard to meet their once-highly-regarded AAA standard. Yet, in reaction to the news, the USD strengthened and Treasuries were aggressively bid up. In other words, the US downgrade saw the market actually buy the exact assets it was worried about," he says.
In the case of the fiscal cliff, Bloom says, cognitive dissonance will likely prevail again: "We have no doubt that a "risk-off" situation driven by the fiscal cliff will see the market buying the USD. One would have to be either brave or foolish to stand in front of this dissonant train."
But once the dollar rises in that scenario, Bloom says, start selling.
"Eventually the market will be unable to cling to this bizarre view and the USD will have to fall back down again."