RISK-ON/RISK-OFF: FX IMPLICATIONS EXPLAINED

What is a risk-on/risk-off regime?

The financial markets often swing between two distinct sentiment dynamics commonly referred to as “risk-on” and “risk-off” regimes. These terms describe changes in investor appetite for risk, which significantly influence asset classes across the globe, particularly foreign exchange (FX) markets. Understanding these regimes helps both institutional and retail investors anticipate short to medium-term movements in the value of currencies.

Risk-on describes a market environment where investors exhibit a strong appetite for risk. Confidence in economic growth, stable geopolitical dynamics, and dovish monetary policy typically underpin this regime. In these periods, capital flows into higher-yielding or emerging market assets, commodities, equities, and riskier currencies such as the Australian dollar (AUD), New Zealand dollar (NZD), and South African rand (ZAR).

Risk-off environments reflect a retreat from risk, often triggered by fears around global economic downturns, geopolitical conflicts, pandemic threats, or restrictive monetary policy. In such situations, investors prioritise capital preservation, frequently shifting their portfolios towards safe-haven assets, including gold, U.S. Treasuries, and so-called “safe-haven currencies” like the U.S. dollar (USD), Japanese yen (JPY), and Swiss franc (CHF).

This binary sentiment shift impacts portfolio allocations across asset classes, but its influence on FX markets is particularly pronounced due to the global nature of currencies and their sensitivity to capital flows. The frequency and intensity of these shifts can drive volatility and shape trading opportunities for FX participants.

These regimes are not always clear-cut and can coexist or flip rapidly depending on news flow, central bank decisions, or macroeconomic data, making it essential for participants to closely monitor sentiment indicators and positioning trends.

Common risk indicators include:

• Volatility indices (e.g., the VIX index)
• Credit spreads in bond markets
• Commodity prices such as oil or copper
• Major equity indices and correlation trends

In sum, understanding risk-on/risk-off dynamics provides a core framework for interpreting broader market shifts and aligning currency strategies accordingly.

FX performance in risk-on environments

During risk-on regimes, the hunger for higher returns leads investors to chase yield and growth prospects, directly affecting exchange rate dynamics. Currencies tied to commodity exports, strong economic growth, or high interest rates are typically among the beneficiaries.

Currencies like the Australian dollar (AUD), New Zealand dollar (NZD), and Canadian dollar (CAD) often gain strength. These are referred to as "commodity currencies" due to their economies' reliance on mineral and agricultural exports. When investors grow more confident in the global economic outlook, demand for commodities rises, supporting these currencies through a positive feedback loop of trade and capital investment.

Emerging market (EM) currencies such as the Brazilian real (BRL), South African rand (ZAR), and the Mexican peso (MXN) also perform well in risk-on regimes. These offer higher yields and, when global risk sentiment improves, see strong inflows as traders look to benefit from interest rate differentials (carry trades) and economic growth stories.

The U.S. dollar (USD) tends to weaken during these phases, especially against high-beta currencies, reflecting reduced demand for safety. The euro (EUR) may also post gains if confidence in the eurozone recovery aligns with broader risk appetite. However, gains in the JPY and CHF are often limited or negative, as their safe-haven appeal wanes in upbeat environments.

Differentiating between cyclical tailwinds and structural drivers in risk-on periods is essential. For instance, if the U.S. Federal Reserve maintains loose monetary policy alongside global optimism, the dollar may face compounded downside forces. Conversely, if economic divergence favours U.S. growth while other economies struggle to recover, the dollar might still achieve gains despite prevailing risk-on sentiment.

Key FX themes during risk-on:

• Increased popularity of carry trades due to higher appetite for interest rate differentials
• Strength in commodity-linked and emerging market currencies
• Pronounced correlation between equity markets and pro-cyclical currencies
• Weak demand for traditional safety plays like USD, JPY, and CHF

Traders and investors following a risk-on theme should monitor equity flows, commodity prices, and interest rate expectations. These directionally influence which countries and currencies attract capital, enhancing return potential in pro-cyclical FX strategies.

Safe havens in risk-off markets

In risk-off regimes, market sentiment swiftly shifts from return-seeking behaviour to capital preservation. This pivot profoundly impacts the forex market, reshuffling currency preferences in favour of traditionally defensive positions.

The U.S. dollar (USD) is often the primary beneficiary. As the world’s reserve currency supported by deep liquidity and the global dominance of U.S. capital markets, the dollar rallies in times of stress. Investors sell risk assets and repatriate funds into greenbacks, especially when deleveraging or covering positions. Additionally, central banks may boost dollar reserves as part of contingency planning, reinforcing USD strength.

The Japanese yen (JPY) exhibits safe-haven demand due to Japan’s significant net external creditor status. During crises, Japanese investors often repatriate offshore income, supporting the yen. The currency also benefits from entrenched low yields, as the cost of unwinding carry trades means global investors must buy back JPY positions initially sold during risk-on periods.

The Swiss franc (CHF) also performs strongly in risk-off episodes. Backed by Switzerland’s strong political neutrality, robust finances, and lack of sovereign debt concerns, the franc is viewed as a stabilising currency by global macro investors. The Swiss National Bank may sometimes intervene to restrain appreciation, which market participants track closely.

Conversely, higher-yielding EM currencies suffer the most. Liquidity constraints, volatile capital flows, and rising risk premiums often trigger selling in currencies like the Turkish lira (TRY), Argentine peso (ARS), or South African rand (ZAR). Commodity currencies (AUD, CAD) also generally fall unless the underlying commodity sectors cushion the blow.

Characteristics of safe-haven flows in FX:

• Tendency to favour currencies from countries with current account surpluses
• Rapid unwinding of carry trades, boosting funding currencies like JPY or CHF
• Preference for low-beta FX markets and low-yield volatility profiles

The level of risk aversion can be measured through indicators like the CBOE Volatility Index (VIX), credit default swap spreads, or sovereign bond yields. These act as visual cues for real-time hedging sentiment, informing traders whether to pivot towards safe-haven strategies.

In sum, managing an FX portfolio in a risk-off climate involves swift rotation into defensive currencies, disciplined exposure management, and a keen eye on correlation shifts across macro instruments. Understanding how and when safe havens gain traction is instrumental in mitigating drawdowns during market turmoil.