There is a wide range of financial jargon used when talking about markets and although some of it is probably quite clear, it isn’t always and so it’s always good to refresh ourselves now and again with the meanings of some of these terms.
A few phrases that seem to be particularly popular lately are “safe haven flows”, “risk-on risk-off” and “commodity currencies” so lets take a look at what these terms mean and how they relate to the markets and your own trading.
Safe Haven Flows.
The term safe haven flows refers to the flow of capital into “safe haven” currencies. Safe haven currencies are currencies deemed by investors to be low-risk, and so in times of uncertainty, investors feel it prudent to move capital out of higher yielding, higher risk currencies and assets and back into lower yielding, but lower risk currencies to protect their capital.
What Are Safe Haven Currencies?
Countries with strong economies are deemed the safest place to store capital in times of economic uncertainty as there is a lower likelihood of these currencies suffering acute devaluations amid market turmoil. Aside from having a robust economy, characteristics of these safe haven countries include a stable political landscape and high liquidity.
Which Are The Safe-Haven Currencies?
Traditionally the currencies which are classed as “safe-havens” are the Japanese Yen, the Swiss Franc and the US Dollar.
Arguably it is clear that these countries don’t exemplify all of these characteristics but having been traditionally seen as safe-havens, their perceived safety in times of uncertainty retains their investor appeal.
Japan sees strong safe-haven in flows in times of global uncertainty due to its large amounts of foreign investment. When risks are perceived, investors repatriate their capital from the chose countries of investment and convert it back into their native Yen buying Japanese Government Bonds.
Switzerland’s historical position of political neutrality has made it a popular safe-haven destination for concerned capital holders, however the popularity of this currency has seen appreciate greatly in recent years with the Swiss National Bank having to enforce a currency peg between the Franc and the Euro in 2011 to stop it appreciating any more. The peg was abandoned in January of this year in the face of the ECB’s huge 1 trillion Euro QE program. Following the removal of the currency peg it seems that the Swiss Franc is no longer as appealing as it once was with investors choosing to store capital in the Japanese Yen and US Dollar during recent global risk-off periods.
The US Dollar as the most highly liquid and widely used currency in the world is often an investor favourite amid rising global risks with the saftey of US Treasuries sought by domestic and foreign investors alike. As with the Japanese Yen, a large part of the support that the Dollar sees in times of global uncertainty is due to domestic repatriation of foreign held investments.
So if safe haven currencies strengthen in times of global uncertainty does that mean that the Euro is a safe-haven?
The Euro has been experiencing an interesting order flow dynamic this year. Following the ECB’s QE announcement in January the Euro has been used as a “funding currency” whereby investors look to take advantage of the incredibly low interest rates in Europe, borrowing the capital which is then used to invest in higher yielding currencies. As various global issues over the year have damaged investor risk appetite these carry trades have been unwound with investors having to buy back Euros to close out their position.
Similarly, QE in Europe has driven another interesting dynamic where investors have been buying European equities and hedging their position through being short the Euro. As equities fell amidst global uncertainty the amount of the hedge becomes greater than the value of the equities position and so investors need to buy the Euro to rebalance this. Obviously the investors could simply sell their equities position but as the hedge amount is still larger than the value required for settlement so they still need to buy the Euro. It is precisely the combination of these two order flow dynamics that have seen the Euro supported through global risk aversion, not that the Euro has been seeing safe-have inflows and this is an important distinction.
Risk-On Risk-Off Or “RoRo”
“RoRo” refers to the shift in capital flow between pro-risk investor activity and risk-aversion investor activity.
So what is typical of investor activity during risk-on periods?
During these periods global equity markets will be stronger, commodities market will also perform better whilst fixed income markets will weaken as investors move out of low yielding, protective assets to chase higher returns in riskier markets. In this environment currencies are generally left to trade on the basis of their individual fundamentals or under the direction of broader market themes, such as the anticipation of a US rate rise which we have seen dominating markets this year. The exception to this is commodity currencies which tend to appreciate in risk-on periods as commodities strengthen.
In risk-off markets we typically see the reverse of the situation above, where equity markets fall alongside commodities, as fixed income markets strengthen. Currencies are far more affected by specific investor inflow as investors seek to protect their capital by moving into the safe haven currencies we discussed earlier.
The so called commodity currencies, namely the Canadian, New Zealand and Australian Dollars, derive their pseudonym from the fact that each of these country’s economies is heavily dependent on the exporting of certain commodities such as Iron ore for Australian, Dairy for New Zealand and Oil for Canada. When these commodities strengthen in value, so too does the value of these currencies due to the increased revenue from exports. Similarly, when these commodities weaken, the commodity currencies sell off dues to the lost revenue from declining export income.
So now you know what these terms mean, how do they apply to your trading?
The correlation between safe haven flows, risk-on risk-off and commodity currencies can highlight opportunities but can also protect against losses.
If for example news hits the wires that is damaging to global economies, such as we saw in August when we started getting big misses on Chinese data followed by wild a sell-off in Chinese equity markets, we can judge the response of various markets to gauge how this will affect currency markets. We saw global equity markets selling off in response to the situation in China confirming the move into risk-off mode. Commodities markets also traded lower with commodity currencies following suit and safe haven currencies rallying.
In the event of scenarios such as this we could anticipate that as global equity markets fell amid global economic fears, safe haven currencies were likely to strengthen. So too we could anticipate that falling commodity prices would drag commodity currencies lower.
These are typical patterns of response that we see time and time again and learning to identify them can provide opportunities, such as trading short commodity currencies and long safe haven currencies, a good example of this would have been selling AUDJPY in the days after the flash-crash we saw on August 24th as global risk sentiment deteriorated.
The chart above shows AUDJPY selling off once more having consolidated at the highs made on the day of the spike lower.
Again, understanding these response patterns can help not just in spotting opportunity, but also in protecting against losses.For many traders who rely on purely technical trading systems, there can be some very frustrating days when markets seem to totally disrespect these systems and their typical trade setups fail. We often see this in a currency pair in response to a surprise figure on an economic release but these seemingly unstoppable flows also occur on days when risk-on risk-off flows are shifting and so learning to be aware of what is happening in the broader inter-market environment can help potentially help you avoid some losses such as those that would occur if you were selling safe-haven currencies during a risk-off period.
For more information about various terms used in Forex trading, check out our glossary here and to learn more about the different order flow dynamics and correlations discussed, check out our Forex Trading Course.