Hurricane Sandy knocked the US markets offline earlier this week and subsequently created a significant interruption in transmitting the sentiment from one session to the next – building momentum to develop definable trends. Not only was the volume from the New York markets missed, but often times significant developments in risk trends begin during this speculative-heavy session. However, picking up where we left puts risk trends and speculative bulls in a risky position.
Read the Introduction to Risk Trends and the Risk-Reward Indicator Here.
In the Risk-Reward Index above, we can see that weekly changes have grown more and more reserved. Technical traders will recognize this is happening as a rising channel from the June low now comes into conflict with the 15-month high 2.00 reading. In other words, we are at a cross roads. This fits the fundamental assessment as well. Slowing growth, a retreat in corporate earnings and the prominence of financial crises create a severe risk against a very limited potential for return.
We see these individual components to this equation below. The ‘Reward’ measure (an aggregate of the 10-year bond yields for the majors) is hovering modestly above its historical low and took a 2.9 percent dive just this past week. Do we see the potential for yields to rise abruptly in the foreseeable future? That is highly unlikely. On the other hand, a Forex Volatility Index at five-year lows is extreme and unlikely to hold that low given the collective uncertainty. Risk is far more likely to increase rapidly, and that means risk trends are more likely to drop.
Risk–Reward Index vs Market Standards
Interestingly, over the past month, we have seen a serious drop in the S&P 500 while the Risk-Reward Index has yet to make its own serious adjustment downward. Another phase lower for the Index (break below 1,400) will likely rectify that as it would likely incite enough ‘fear’ to lift volatility measures.
Majors Correlation to Risk Trends (How Influential is Risk Appetite)
Below, are charts that show the price action for the majors against the correlation that the pair runs against the Risk-Reward Index. The closer to 1.0 the correlation, the pair will move in lock step with risk appetite (optimism rises and so does the currency pair). On the other hand, the closer a reading is to -1.0 means the closer the pair moves in exactly the opposite direction but at the same pace as risk trends.
This is valuable information for fundamental traders. If you recognize a currency pair is highly correlated (positively – close to 1.0 or negatively – close to -1.0), we know that we should be watching factors that change sentiment to offer us guidance on that particular pair. Alternatively, the closer to 0.0 the reading, we know that there is less influence from risk trends and we can trade independent of that bigger theme.
--- Written by: John Kicklighter, Chief Strategist for DailyFX.com
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