The effect of the Risk On, Risk Off Trade is to cause asset correlation to become more positive.
What is the Risk On, Risk Off Trade?
Since the financial crises in 2008 there has been a growing trend of investors, particularly institutional investors, to buy risk (risk on) when inflation is the leading prospect for the economy and sell risk (risk off) when deflation is the leading prospect for the economy.
- Risk On = Long: Stocks, Commodity Currencies (Australian/Canadian/New Zealand), Energy & Food Commodities. Short or Avoid: Bonds, Non-Commodity Currencies including the U.S. Dollar.
- Risk Off = Long: High Quality Bonds (U.S. Treasuries), Non-Commodity Currencies including the U.S. Dollar. Short or Avoid: Stocks, Commodities, and Commodity Currencies (Australian/Canadian/New Zealand).
The theoretical basis for the Risk Trade is the tug of war between inflationary and deflationary forces. When inflationary forces are perceived as gaining ground, then risk on. When deflationary forces are perceived as gaining ground, then risk off.
Asset Correlation Increases with Risk Trade
The effect of the Risk On, Risk Off Trade is greater volatility and more importantly greater asset correlation. The mass movement of large institutions and investors all in or all out of asset classes has caused many assets to become highly correlated.
The evidence is clear. Since 2008 investments such as stocks, commodities, gold, oil, and agricultural commodities are highly correlated. In other words, they move up and down together.
This is a dangerous trend for investors who believe they have protection because they have a “diversified” portfolio. Holding different assets such as stocks, gold, commodities, and currencies use to provide some protection. But asset correlations have become much more positive the last few years as the risk trade causes everything to be bought together and then everything to be sold together. If asset classes move together then investors may not be as diversified as they had planned.
How to Monitor Risk On, Risk Off
Of course it’s easy to see risk on, risk off after it has taken place. The evidence is clear by looking at what assets are rising; risk on assets or risk off assets?
Investors can try to anticipate the next risk trade by looking at the markets perception of inflation. An accurate gauge of inflation expectations can be found from the differential between the 10 year Treasury Nominal Bond Rate (2.66% in March 2014) and the 10 year Treasury Inflation Protected Securities (TIPS) yield (0.61% in March 2014).
The difference between the Nominal and TIPS yields will provide you with an anticipated inflation yield of 2.05% per year over the next 10 years. In a previous post I have explained how it is the inflation trend, not the absolute rate of inflation, which is most important in making investment decisions. If that anticipated inflation yield trends higher, that is inflationary, and would tend to favor Risk On. If the anticipated inflation yield trends lower, that is deflationary, and would tend to favor Risk Off.
How to Mitigate the Effects of Risk On, Risk Off
The increased correlation of assets makes Cash a more important asset class even at zero rates of return. Investors should hold more cash than they would have before correlations rose to these new record levels. Cash preserves your portfolio when most assets (risk off) are falling and preserves capital for investment when bargains become available.
Related Reading: Risk Management