Risk sentiment and changing market regimes

Prerequisite: Reading a currency pair

On a small screen, scroll the figure sideways or open it full size.

Learning objective

Describe risk appetite without assigning permanent safe-haven rules.

Risk-on and risk-off are descriptive labels for investors’ willingness to hold uncertain assets, not measurable switches with a single agreed definition. Equity returns, credit spreads, volatility and funding conditions provide different clues. Several clues can conflict during the same session.

Currencies sometimes labelled defensive can weaken when their domestic fundamentals deteriorate or investors need another funding currency. Gold may be sold during urgent cash demands even amid fear. Associations observed in one crisis or sample are conditional, not permanent laws.

A regime description should state time horizon, instruments and evidence. Separate observed returns from explanations such as growth fear or liquidity stress. Use alternative hypotheses and compare them against additional data, instead of relabelling every move after the fact to make your story fit.

Common mistakes

Correlation is not causation. Avoid using a volatility index as a direct probability that a market will fall.

Practice

Choose a historical stressed week. Record four asset returns and write two competing explanations, including one piece of evidence against each.

Sources & further reading

• CME Group — Fundamentals and FX Futures
• Chicago Fed — What Drives Gold Prices?