FX Monthly – Waves of investor sentiment

by: Georgette Boele

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Waves of investor sentiment

Over the past few years, we have experienced various phases of investor sentiment. In these phases, financial markets have shown distinct modes of behaviour and currency markets have been no different. In this FX monthly we focus on the behaviour of currencies – both in terms of direction and volatility – in different market environments. We define five specific environments: market panic; elevated risk aversion; moderate risk aversion; moderate risk seeking and extreme risk seeking.

Market panic aligns all risk indicators

In a market panic, which is often coupled with a liquidity crunch, all the risk indicators are aligned and set new historical highs. The JPY and the USD are the ultimate safe haven currencies. The USD does particularly well if there is a sense of liquidity shortage. Moreover, emerging market currencies – such as BRL, MXN and ZAR – reach their extreme levels before major pairs. The TED spread turns to lead our currency market volatility indexes – both on the way up and the way down – in this scenario.

Behaviour during elevated risk aversion depends on origin of crisis

Although risk indicators are also aligned in terms of direction during elevated risk aversion, the origin of the crisis makes a difference. In addition, the reaction on the individual currency levels differs as well. For example the SGD was the least sensitive in the case of the attack on the World Trade Centre in September 2001, while the SEK was far more sensitive than the NOK. In the eurozone debt crisis European currencies reacted first and investors were open for less-liquid euro alternatives without break-up risk such as the GBP, SEK and NOK.

In moderate or local risk aversion the origin of the crisis plays a more important role

During moderate risk aversion, the origin of the crisis plays a more important role for the behaviour of volatility and underlying. Spread indicators (like the TED) barely move though. The USD, the Japanese yen and to a lesser extent the Swiss franc and the Singapore dollar behaved as safe haven currencies. But the USD only rallied if the US was not at the epicentre of the crisis. In a risk seeking environment, investors are very selective. Well-thought investment decisions result in divergence between risk indicators and in the behaviour of underlying.

In extreme risk seeking investors are blinded to the risk they take

If investor sentiment improves further towards extreme risk seeking, risk indicators align and volatilities drop. Some volatilities drop faster than others. Volatilities in the major currency pairs drop the most, while higher yielding currencies show the largest appreciations. In some cases trends continue even though volatility started to move higher.