Ever wonder what they’re talking about when they say that the markets are in “Risk-Off” or “Risk-On” mode? Ever wonder what indicators to look at to determine which mode the markets are in on any given day? The increased volatility over the past few trading days provides us an opportunity to explain what these terms mean.
Risk-off mode simply describes a market environment whereby fear suddenly overtakes greed as the dominant investor mindset. As a result of this rotation we observe a temporary drop in aggregate risk tolerance. It could be anything that triggers the renewed sense of fear. Sometimes a poor economic report, like an increase in the unemployment rate, is enough to do the trick. Other times it could be a geopolitical concern that causes a temporary rush to the exit signs. Or a change in fiscal or monetary policy might catch investors off guard. It really doesn’t matter what the cause is. The point is that, unlike a bear market, these rotations are usually unexpected but generally short-lived and shallow.
The markets were clearly in Risk-off mode late last week. The fears were triggered by projections for Hurricane Irma-related losses of up to $200 billion, the possibilty of another North Korean missile launch over the weekend, and possibly Trump’s decision to side with Democrats and extend the debt ceiling debate through December (deferring the final resolution of this thorny issue). With these outstanding issues going into the weekend, investors decided to take some chips off the table. It is not uncommon to see this kind of volatility prior to a weekend that carries some uncertainty.
Risk-on mode, on the other hand, is when greed overtakes fear, and investors adopt a more risk-tolerant disposition. The markets clearly shifted into risk-on mode with the opening of trading on Monday morning this week. The rotation was triggered by several developments over the weekend and early this week. First, the weekend passed without another provocative missile test by Kim Jong Un. Second, a westward shift in the path of Hurricane Irma reduced loss estimates from about $200 billion to a little more than $50 billion, according to one estimate reported in a Bloomberg article. And third, investors may be somewhat encouraged about the news from the US Census Bureau that median family income rose over 3.2% in 2016, after adjusting for inflation, following a 5.2% increase in 2015. There may be other factors boosting optimism, but those are the most likely.
So what indicators can you observe as tangible evidence of a “risk-on” or “risk-off” investor disposition? The shift to risk-off late last week and then to risk-on this week led to volatility in the following markets:
- The dollar dropped over 1% late last week only to recover most of the losses this week. The drop in the dollar last week probably reflected fears of a hurricane-related deceleration in economic growth and possibly the deferral of the debt ceiling issue until December.
- The odds of another Fed interest-rate hike by year-end dropped to as low as 22% late last week only to climb to about 39% as of today. Apparently, investors now believe that a double dose of hurricanes and/or the North Korean threat won’t be enough to derail the economy’s underlying strength or an expected acceleration in inflation.
- The S&P 500 dipped slightly late last week reflecting the aforementioned risk factors. However, a larger drop and rebound occurred in the technology-laden Nasdaq 100 Index, which dropped close to 1% on Friday only to gain it all back on Monday. We would expect to see the more volatile technology stocks drop more than an index like the S&P 500 in a “risk-off” market.
- The yield on the 10-year Treasury bond has been a conundrum to many investors (and central bankers) because they cannot understand why yields keep falling in a reasonably strong economy. Late last week, the yield on the 10-year Treasury bond nearly breached the psychologically important 2% level. However, yields have rebounded so far this week to 2.17% as fears recede and bond prices fall on the reversal of the “flight-to-quality” trade we saw late last week.
- The Volatility Index, also called the “VIX” or the “Fear Index”, has fluctuated as you would expect. The Index generally rises with increasing fear, and drops with increasing risk tolerance.
- And finally, the behavior of gold is probably least useful as a gauge of fear and greed this past week as the gold price has been rising in fairly uninterrupted fashion (up 10%) since early July. However, gold has historically been a ‘flight-to-safety’ asset that does well in a “risk-off” environment.
We must close by saying that rarely is the backdrop unambiguously positive or negative. During our current bull market, which is in its ninth year, investors have displayed a strong propensity to embrace all good news while dismissing any bad news. While we do get these brief “risk-on, risk-off” spurts from time to time, the trend in stocks is unambiguously higher. And trends have a tendency to last longer than anyone expects. Perhaps this is why every small dip in stock prices is being greeted with an army of enthusiastic buyers. Enjoy, for this too shall someday pass.