I was hoping you could help me out a little with risk aversion and risk appetite. Basically my question is how do you determine when risk appetite or aversion is creeping into sentiment. For example with the A/U currency. If we have good news coming out of both countries and sentiment is short as the news coming out of the US is better showing a strong economy, good employment levels, GDP etc etc, how do you determine when risk appetite is kicking in and lifting the A/U when fundamentals and news hasnt necessarily changed in favour of the aussie economy.
Your thoughts would be most appreciated.
With regards to whether risk appetite / risk aversion is “creeping into sentiment,” – I would interpret that as meaning that you are wondering if the AUD/USD is moving up or down and causing volatility movements based on shifts in risk appetite / risk aversion. So you are wondering whether the risk appetite / risk aversion is “creeping into the volatility” and is a potential scenario and explanation for the AUD/USD movements up or down?
One of the ways to determine if AUD/USD is sensitive to risk appetite is to ask yourself – well what are the ways to determine a risk appetite day? One of the ways is to see if there was good economic data out of a big GDP country – say the U.S. Thought you also want to look at what the market response is, to check on the market sensitivity. There can be good US economic data, but are the markets responding to it in a decent way, or are they shrugging it off?
So one of the ways to check is to say – look at a chart of the S&P 500 futures. If they go up, that can mean that the market is having a risk appetite day. So you can check over the past 2-3 months and see the days when the S&P went up, did AUD/USD go up? Or stay flat? Or go down?
For example on January 14-15, the S&P had two up days in a row, while the AUD/USD had two down days in a row. This shows that AUD/USD was not responding to the risk appetite scenario. So that was a very interesting situation and deserved further attention and research. There was and has been AUD specific bearish macro catalysts that have occurred over the past few months from last November 2013. With the RBA saying the currency is too strong, RBA downgrading growth forecasts, and that the AUD/USD should drop when the Fed starts tapering, and the potential for China slowdown, etc.
So if you look at a daily chart of the S&P and AUD/USD from October 2013, you can clearly see that the S&P has been going up, while the AUD/USD has been going down. Now, that does not mean they have a negative correlation (as one goes up, the other has to go down), rather it gives you an interesting situation for you to do a bit of extra research to determine the catalysts and reasons why the AUD/USD is going down, so you can drill into the country specific macro situation and catalysts for the move. You don’t need an exhaustive 3-5 page report on the country specific catalysts, rather you just have to boil it down into 3-5 bullet points. Sometimes all you need is one key insight that is not priced in yet, or just a 2-5 key catalysts / scenarios that can come into play.
Risk appetite / risk aversion can potentially come from different locations. There isn’t necessarily one central country from where risk appetite / risk aversion can come from. Risk appetite / risk aversion can potentially come from US data, Europe data, China data, etc.
For example, if the market is expecting a sluggish recovery in the U.S., but if the data picks up, the market can go into risk appetite mode. But that does not necessarily mean there will be the traditional S&P goes up, USD/JPY goes up, EUR/USD goes up, AUD/USD goes up, etc. That type of risk appetite did happen in the past at some moment in time (because the market may have thought the US would still keep interest rates low), but the way the market responds to the data can change. It was possible that was how the market responding to the better US data in the year 2011 lets say, but in the current market environment, the market responds differently.
In the current environment the S&P and USD/JPY did go up over the past few months, even though China growth was anticipated to slow a little.
If the market believes that the growth outlook in China/Australia and US are diverging, then better US data, may not be enough to raise growth prospects in China/Australia. Better US data does of course help global growth, as does better Eurozone data, better China data, etc. Though there are sometimes when the economic growth outlooks for various countries diverge due to country specific monetary policies, or changes in commodity prices, or other government policy. So China is growing at a strong 7% + per year, but compared to the growth that they had a few years ago, it has slowed down a lot, and the market is trying to reprice for that scenario. And the Chinese government seems to know they have a few systemic problems in the Chinese economy with a lot of potentially bad loans in the banking system and housing market, and they may have built too many factories, leading to oversupply, pollution problems, etc as they tried to artificially raise the growth rate in order to create jobs for the massive population. So they are trying to correct the excesses of the past and engineer a soft landing. That anticipation of the lower China growth rate led to a decline in demand for Australian commodities, and some commodity prices fell. And that seems to be causing Australian growth rate to go lower. The RBA tried to offset that with interest rate cuts, but the interest rate cuts cannot benefit each sector of the AUD economy equally. There may be some interest rate sensitive sectors of the economy that get a boost from it, but there may be certain export oriented sectors of the AUD economy that do not feel the benefits of the interest rate cut, and they would prefer AUD depreciation in order to help boost AUD growth and jobs. So the RBA has tried to use verbal intervention in order to weaken the Australian dollar so they can help the sectors of the economy that would benefit from a weaker currency.
As the book Hedge Fund Market Wizards describes part of Ray Dalio’s philosophy:
Dalio’s view that changes in expected growth and expected inflation are the dominant reasons that some asset classes do well when others do poorly.
To sum it all up, the key insights that you can use are:
1. Just because stronger US data comes out, that does not automatically mean the AUD/USD will rise on risk appetite. The key questions become: How will the macro order flow be for the different scenarios: How much faster will the market believe the Fed will taper because of the stronger US data, versus any boost to AUD growth from the stronger US growth helping global growth? If the market generates more bullish USD macro order flow due to the Fed taper scenario, and believes the boost to AUD economy from stronger US growth is relatively little or not related, then the AUD/USD can drop on better US data / risk appetite. The AUD may be moving more on China news, and AUD specific economy news, rather than any general risk appetite / risk aversion.
2. Compare the AUD/USD to a cleaner risk appetite financial instrument such as the S&P.
3. First and foremost try to analyze each individual currency and financial instrument separate from each other. For the AUD/USD, ask first, are there any AUD bearish specific catalysts, or USD bullish specific catalysts, that can cause the AUD/USD to drop? Try to locate those first. Whether they exist or not, then move on to comparing the AUD/USD to other financial markets and seeing how changes in other economies can affect other countries and markets around the world.
In order for the AUD/USD to rise on general global growth risk appetite, in would require a shift in certain scenarios. It would require some combination of the China data to stabilize and move higher as well as the AUD economy to not lose jobs, unemployment not to rise, RBA to stop verbal intervention, AUD growth to pick up, etc. And of course, to be checking the AUD/USD market response to risk appetite news from around the world.