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What is Risk On and Risk Off

20 Jul 2021 ‚óŹ 04:48 AM

How can bond yields be falling and the dollar be going up? This was a question that was posed to me on Twitter and it takes me back to a chart of the US bond prices v/s US equities [DJI] which I have used many times before to explain the inverse relationship between these two assets. Most US Investment managers move money between these two assets and this action is coined as the risk parity trade. Sell stocks and buy bonds or sell bonds and buy stocks. The first is a risk-off trade and the second is a risk-on trade. Now sell stocks does not mean a market crash always. Sometimes it’s a routine correction or just a consolidation phase. Thus whenever bond yields are falling [rising bond prices] you see what you are seeing today, fear of a market decline.

Since the media has spent so much time creating the fear of rising interest rates we start believing that rising rates are bad, however, they are only a manifestation of a rising market that represents improving economic conditions. So it is not always bad. It is bad when that trade ends.

In March 2020 I noted that the Daily Sentiment index was at 8% for the bond market, meaning that 92% of the traders were bearish on the bond market and therefore bond yields will stop rising. In hindsight that was a perfect thing to expect. Recently I have noted that the 30-year bond [T-bond] has a DSI of 91%. Yesterday as bond yields declined we got the same reading for a second time. It means that bond yields might be getting close to the point where they stop declining. Treasury notes at 83% are not far behind. We can say that the bond market rally is now in the late stages and should be closer to turning down. That means that yields will start rising again. But that will inevitably accompany rising stock prices as it has for years.

But what about the dollar. When there is a risk-off trade and stocks decline we have often seen money move out of risk assets and drive up the dollar as money leaves foreign markets and reverts to the US. Therefore a risk-off trade is both rising bond prices [falling yields] and a rising dollar. A risk-on trade is both a falling dollar and falling bond prices [rising yields]. While sentiment on the dollar or Euro is not extreme, the bond market may be an early signal of a trend reversal for the dollar as well. A shift from the recent risk-off environment to risk-on would bring back liquidity and foreign money flows to Emerging markets. We are almost there but this is a game of patience. The chart below shows a potential ending pattern on the dollar index that I am waiting to see play out. The daily momentum indicator is already in sell mode with multiple divergences but we need an actual price reversal with a break of the wedge on the downside.

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