Avoiding Risk On / Risk Off with Crosses

Since the financial crisis broke out in 2008, the US dollar often reacts “rationally” to US indicators and sometimes “irrationally” – falling on good data and rising on weak data.

Here’s how it works, and how to avoid it, using crosses (although not all of them):

Risk On / Risk Off

The US is the world’s No. 1 economy and is still considered the global locomotive of economic growth and weakness. When the global mood is poor, the risk aversion / risk appetite behavior is clearly seen.

This means that weaker than expected US indicators are bad news for the whole world, and therefore investors move to the “safe haven” US dollar and Japanese yen, avoiding “risk” in other currencies such as the euro, pound, the Australian dollar and others. That is risk aversion or “risk off”.

When positive indicators are released, it is a relief for all the world, and the outcome is more risk taken – selling the US dollar for “risk currencies”. This is risk appetite or “risk off”.

Normal Behavior Thanks to QE3 Expectations

Sounds counter-intuitive, but this is too often the case. Too often, but not always the behavior you see. One of the strongest movers of the dollar is easing moves by the Federal Reserve, or the expectations for them. Expectations for a third round of quantitative easing (QE3), even if they are not logical, weaken the dollar. Lower expectations for QE3 strengthen it.

Good US indicators mean a lower chance of QE3, therefore strengthening the dollar, and weak indicators raise the chances, hurting the greenback.

So it’s logical behavior after all? This changes all the time.

Crosses

So, instead of trying to figure out which behavior characterizes markets, another approach is to take the US dollar out of the equation, trading crosses.

By trading crosses such as EUR/GBP, GBP/AUD, AUD/CAD, EUR/NZD and quite a few other ones, you can avoid the mood swings related to the US dollar. These crosses will still shake when US indicators are released, as not all the currencies react in the same way against the greenback, but this will likely be more limited.

Out of all the currencies that can make a cross, it’s important to note two exceptions:

Yen crosses: The Japanese yen is also a “safe haven” currency. It tends to have a normal behavior against the dollar on US indicators (USD/JPY rises on good data and falls on bad data). However, the behavior of the yen against other currencies depends on the mood in the markets.

EUR/CHF: The Swiss National Bank put a floor of 1.20 under the cross and is guarding it very successfully. The floor recently turned into an effective peg. So, this cross doesn’t really move, and the Swiss franc actually mirrors the movements of the euro, across the board.

Trading crosses might not provide the same volatility as trading the majors and the minors. Nevertheless, the movements of these crosses are much more correlated to the fundamentals of the underlying currencies and not to global mood swings.

Further reading:  5 Most Predictable Currency Pairs – Q2 2012