Trading on Risk Sentiment? Be Careful

Businessman with crystal ball
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Businessman with crystal ball

Risk appetite has been a good predictor of currency moves ever since the financial crisis, but that's changing.

It's been axiomatic in the FX markets that when investors are hungry for risk, certain currencies are poised to rise - and vice versa. But the strategists at Brown Brothers Harriman have taken a look at those relationships, and things are changing.

The euro's moves were almost perfectly correlated with the rises and dips of the S&P 500 index in December, says Marc Chandler, chief currency strategist. "The correlation over the last 30 days now stands near 0.42," he wrote in a note to clients. Meanwhile, the yen had a 0.42 correlation with the S&P 500 in January, but at -0.11 the 60-day correlation has now gone from positive to negative. And of course, the dollar used to sink when rising stocks signaled a pickup in risk appetite, but it has been rising along with stock prices and Treasury yields.

"The breakdown in correlations shows there is now less attention being paid to risk-on, risk-off" shifts, says Mark McCormick, a Brown Brothers currency strategist. "The stocks up, dollar down dynamic isn't holding as much. We are shifting toward the more fundamental outlook for growth."

McCormick says better indicators to watch now are in the bond market, like the steepness of the Treasury yield curve. "A sharp rise in the 10-year yield is indicative of improvement in the U.S. economy and perhaps the outlook for Fed policy," he explains. And since an improving economy lowers the likelihood of further quantitative easing, "that is resulting in a stronger dollar."

He also watches spreads between two-year yields in the U.S. and Germany, and the U.S. and Japan, for clues to the likely direction of the euro and the yen.

Good luck out there.

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