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 How Does The FX Market React On Geopolitical Risk

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PostSubject: How Does The FX Market React On Geopolitical Risk   Wed Nov 18, 2015 10:19 am

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 This morning, tragedy struck.  A flight on the way from Amsterdam to Kuala Lampur, was shot down and crashed.  The FX Market acted in a very specific way, as did other markets. On March 11, 2011 a magnitude 9.0 earthquake caused a tsunami to run through Tokyo, bringing the country to a standstill and the FX market reacted in a similar way as it did today.  On September 11, 2001 when a terrorist attack on the World Trade Center, caused the stock market to close for a week, and the market acted in a very specific method. 

How The FX Market Reacts when Disaster Strikes

When disaster strikes, like the three tragic examples above, a common pattern emerges. The common pattern is JPY and to a lesser extent CHF strength.

 The reason that the JPY is bought as well as the Swiss Franc has to do with their very low yields.

Allow me to explain: 

In a very low interest rate environment, money in those countries do not sit idle unless it is scared money.  In other words, when investors big and small, are looking for yield or return of their money, they'll likely look outside of their country because the interest rates are so low.  This causes investors to sell their home currency, such as the CHF or JPY, in order to buy stocks or bonds other counties with higher yields. This strategy is known as the carry trade because investors are selling their low-yielding domestic currency in order to carry the currency with a higher yield and pocket the difference. 

This strategy works well in two environments; the first is an environment where the global risk appetite is high as seen by higher stock markets.  The current environment would qualify as one where global risk appetite is high due to the extremely accommodative central banks around the world.  Secondly, an environment where the Volatility Index or VIX  (attached photo) is in a downtrend also favors the carry trade environment.  The higher the VIX, the more volatility traders in Chicago and around the world are expecting, which tends to favor more risk-avoidance.

Reading Risk-Appetite Through the VIX

The VIX, also known as the fear-gauge, spikes in terms of distress.

The reason for the distress doesn't matter. It could be financial turmoil like the 2008 credit crisis, which saw the VIX touch 100 (the long-term average is 20) or geopolitical risks like we've seen recently but result is the same.

When the VIX pushes higher the FX market sees a rush into the JPY and the CHF. 

Why Is the JPY Such a Strong Mover In Times of Distress

Due to the size of the Japanese economy, the third largest by nominal GDP, and the secular low rates, massive amounts of money moves away from the Japan to find higher yields. Japan owns the world's largest single pension fund, the Government Pension Investment Fund, with over $1 Trillion in investable assets as an example. Because this is a Pension Fund, it is largely interested in preserving capital in times of distress, which would mean selling foreign stocks and buying Japanese Government Bonds, via the Japanese Yen. 

How Do Other Markets React? 

We've discussed that JPY is bought along with CHF in times of global financial or geopolitical distress. This is often accompanied by a spike in the Volatility Index. The other markets that react in similar fashion are a move higher in Gold as well as a drop in global equities. 

Lastly, it's good to know that when the tensions, whatever the cause, cease that these effects reverse.  This means that JPY and CHF weaken along with Gold and global equities often move higher when the global consensus is that it is a favorable time to seek risk again. 

Happy Trading!

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