Risk Factor – Explained

Why does EUR/USD drop when US economic figures disappoint?  This is not normal. But we are not in normal times. Here is an explanation of these phenomenons, also known as “risk aversion” and “risk appetite”.

Since the big financial crisis erupted in the fall of 2008, there have been many such absurd period. The current summer of 2011, which includes an escalating European debt crisis that approaches the core, an unprecedented downgrade of the US and fears of a global recession, is a time when these abnormal phenomenons happen all the time, the “new normal” if you wish. How does it work?

US Indicators Lead

In normal times, the dollar rises on good figures and falls on weak ones, against every other currency. In bad times, the world looks to the US for signs on where the global economy is going.  The US is still considered to be the locomotive of world growth and also of global trouble, even though a lot of the world’s focus has shifted to the Far East, and especially to China.

Apart from providing the lead indicators on the world, the US is also still considered to be a safer bet than many other developed countries, no matter how well they are doing.

So, if the US releases weak economic figures, global fear rises again, and the dollar is sought as a safe haven currency. This is called “risk aversion“. While the US provides the leading indicators, the dollar is definitely not leading in its “safe haven” status.

Safe and Unsafe Currencies

The Swiss franc is at the peak: it has an excellent economy and a solid banking system. It temporarily lost this role during the financial crisis, but returned to the top, and is  unrivaled  now.

The second place goes to the Japanese yen: here the picture is different: the economy is struggling and Japan has a mountain of debt. Yet it still considered very solid.

The third place belongs to the US dollar.

Australia and New Zealand are on the other side of the  spectrum: both countries have solid economies. Australia has a rock solid AAA rating. Nevertheless, weak US figures = danger to global growth = trashing AUD and NZD.

The Canadian dollar also has the same position, but this is more related to its direct dependence on the US. A weaker US = a weaker Canada = a weaker Canadian dollar.

The euro is also in the basket of “risk” currencies, but it is less affected nowadays from US indicators, as it has deepening troubles of its own and on the verge of its own euro printing program.

The British pound is trying to sneak out of the “risk” currencies, with harsh plans to cut deficits, although it still tends to weaken on bad US figures.

What happens when US figures are positive?

In these days, the opposite happens: the US dollar strengthens against the yen and the franc, while losing ground to the rest. This is called “risk appetite“.

This phenomenon is more limited. Why? When a long batch of positive US indicators are released, or when positive surprises are significant, we begin returning to the “old normal”, where the world is more stable, and even has prospects of solid growth.

We are still far from the “old normal”.

I hope this answers many questions I have received in the comments and via email.