In the past week, we have seen a change in market dynamics. The market has finally started to focus on the rising tensions between the USA and North Korea, and we have been observing a slight Risk-Off dynamic all week long.  In this short article we shall review the Risk-On vs. Risk-Off dynamic and what asset classes tend to outperform in either scenario. We will draw on some studies by HSBC which has done extensive work on the subject.

Return On Capital vs. Return Of Capital

The Risk-On/Off dynamic is relatiely easy to spot. The market shifts to “risk-on” when the prospects for the future of the economy are rosy, and shifts to “risk-off” when the prospects turn sour or the proverbial hits the fan. Assets change their behaviour (and diversification is thrown out of the window) and split into two camps: they are either risk-on (“risky” assets) or risk-off (“safe havens”). Diversification benefits are minimized with either strong positive or strong negative correlations between assets. Furthermore, cross-asset correlations tend fo be stable while the underlying theme remains in play (in our case, North Korea).

To rephrase:

  • In a risk-on environment, Return on Capital invested is the primary focus, and “risk-on” assets are in demand and tend to move in sync.
  • In a risk-off environment, Return of Capital invested is the primary focus, and “risk-off” assets are in demand and tend to move in sync.
  • Risk-on” assets tend to move opposite to “risk-off” assets

Event-Driven Dynamic

Risk-on/Risk-Off (or “RORO” as HSBC calls it) intensifies whenever “unsettling” news occurs and is very slow to dissipate. Hence, RORO is an event-driven dynamic and strongly coupled to uncertainty.

The periods indicated by horizontal bars in the chart above (HSBC) correspond to the following market events and conditions:

  • I. “Normal” (2005 to mid 2006)
  • II. “Normal” but awareness of the potential sub-prime crisis (2006 to mid 2007)
  • III. Crisis warnings and early crisis events (Northern Rock) – an increase in correlation
  • IV. Attempt to normalize following early crisis – pre Lehman
  • V. Crisis and correlations intensify – collapse of Lehman Brothers
  • VI. Crisis high point – strengthening correlations
  • VII. Risk on – risk off: high correlations between all markets
  • VIII. Risk on – risk off persist

So while the actual drivers of the risk-on/risk-off dynamic can (and do) change, market participant behaviour has remained largely stable in time and there are some assets that have a strong and stable connection to the dynamic:

Risk-On Assets:

  • Equity Markets (S&P, Dax, EuroStoxx, Dow)
  • High Yield Currencies (Australian Dollar, New Zealand Dollar, Canadian Dollar)
  • Industrial Metals used in construction (Copper)

Risk-Off Assets:

  • Long-Volatility (VIX)
  • Fixed Income Investments (US AAA Corporate Bonds, US Government Bonds above all else)
  • Low Yield Currencies (Japanese Yen, Swiss Franc but also the American Dollar)

There are various reasons for the strong correlations and outperformance of certain “defensive” assets during risk-off events. Here are but a few:

  • In FX, investors utilize carry trade strategies which entail buying higher yield government with the proceeds of contextual selling (funding) of low yield government bonds. The interest-differential is quite evident and even to retail traders it makes a difference. Some brokers openly show the cost of carry for certain currency crosses like EurAud or AudJpy. If a retail trader is long AudJpy and rolls the position overnight, he will likely benefit from the interest differential. If the trade is short AudJpy and rolls the position overnight, he will lose the interest differential.  When the proverbial hits the fan, “defence” becomes the main priority and these positions are unwound as fast as possible causing higher correlation and higher volatility.

Source: HSBC

  • In Equities, when the future prospects for growth are threatened by geopolitical events (North Korea for example), or surprizing negative local events (Lehman Collapse, Brexit, etc.) investors turn to “defensive” assets such as fixed income instruments (since bonds holders receive interest payments independently from the events unfolding).
  • The contextual unwinding of positions causes a rise in correlation and, given crowded trades, also a rise in volatility because the markets will push further than expected. Hence long-volatility instruments benefit (VIX).

Here are 2 heatmaps that illustrate the forces at work. First we have a heatmap during “normal” times.

Source: HSBC

And now take a look at a heatmap from the Lehman crisis:

Source: HSBC

When the proverbial hits the fan, the whole world scrambles for the exit and correlations & volatility rise.


We’ve been talking a lot about the end of QE and what dynamics will unfold. During QE, central banks worldwide started buying up government bonds as well as “junk bonds” that nobody would buy, in exchange for cash. In theory, by raking up assets in exchange for cash, the central banks should have assisted the recovery and through easy credit should also have stimulated the common retail investor to borrow and spend, hence breathing life back into the economy.

This has not happened. QE was unsuccessful for at least 2 reasons:

  • The cash kindly offered by central banks was, I believe, utilized by the investment banks to cover losses during the Lehman period. Investment banks started  buying equities and bonds together because the central bank stimulus would have kept a bid in both asset classes. So the stimulus never really reached the common joe.
  • Confidence never really returned. In order for any solution to actually work, the public must have confidence in the future. And yet, living standards never really recovered to pre-crisis levels. Also, governments took the excuse to place even more red tape (bureaucracy) around transactions in the real economy and the financial economy, making it even more difficult to do business (governments in the G10 generally spend more than 50% of GDP, hence limiting growth prospects).

Here is a heatmap of what QE did to the markets:


Everything was correlated.

Source: HSBC

No diversification, no risk perception. But now the story is ending. Central banks have created the ultimate bubble through their QE plans: a bubble in government debt. Government debt was already unsustainable, and now the bubble is about to burst. Central banks need to unwind their balance sheets and raise rates. But when the largest bidder in the room leaves, who is going to be left?

I do believe that as the ECB follows in the FED’s footsteps, we will start another intense round of risk-off but this time the dynamics will be a bit different: traditional fixed income investments will not be the safe-haven. So what’s left?

  • Long volatility (Vix)
  • Short Carry Trades ( AudJpy, NzdJpy, CadJpy, AudUsd, NzdUsd)
  • Long US Investment Grade Corporate Debt

Over to You

The Risk-on/Risk-Off dynamic is an event-driven process that can result from new economic data, speeches
or reports from central banks, or a reduction in market confidence that erodes risk appetite due to market declines
or geopolitical events.

The drivers can differ and based on the drivers, you can select the most logical risk-off instrument to trade. Just be cautious because when the markets are driven by risk aversion, volatility increases and it doesn’t take much for the market to snap back. In essence, it requires a hands-on approach.

About the Author

Justin is a Forex trader and Coach. He is co-owner of, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.