By Alexander Pearson

After the inexorable decline in commodities and the correction in global equities markets, a ‘risk-off’ attitude has dominated the first few trading weeks of 2016.

A quick glance at the VIX (the CBOE’s implied volatility index, which measures investor sentiment to gauge ‘fear’ levels in the markets) shows that we’ve reached a relative high, which is precisely what one expects following a rout of the kind we’ve just witnessed.

One of the most reliable properties of the VIX, however, is its tendency to mean revert; its value tends to move within a channel, oscillating around an average level. In practice this means that high volatility periods are typically followed by lower volatility periods (and vice versa), and that when volatility reaches extreme levels they are seldom sustained. We’re now at a high ‘fear’ level, and a VIX reversal may well be on the cards.

It may be time, then, to start seriously examining ‘risk-on’ scenarios again, and asking how markets will behave if the current bearish phase is drawing to a close. In this article we’ll take a look at some of the major currencies and consider the implications for each of a shift in market regime towards low volatility and the accumulation of riskier assets.

The US Dollar

It’s arguably the US dollar that has stood to gain the most from the recent capitulation, sporting the cachet that December’s rates announcement brought and providing a potential haven from the troubled waters of the Eurozone and commodity currencies. On balance, though, the dollar was slow to capitalize on the emerging risk trend despite the favorable fundamental context.

The Dollar Index has drifted toward its twelve year high with few signs of strength, aided more by the weakness of its counterparts (weighted equally or by trade volume depending on the index) than its own drive. The most heavily traded pair, EUR/USD, illustrated the Dollar’s lack of resolve with a marginally lower weekly close for the currency.

If the dollar is showing the least strength when conditions have been this auspicious, it may have the furthest to fall if the current deleveraging phase is over and traders begin liquidating the positions they built around the prospect of higher yields.

The Japanese Yen

As a funding currency, a move into ‘risk-on’ trades could have significant impact on the Yen. With rising US stock prices and liquidity moving out of treasury backed securities into more risky assets, we could see a slowdown in the carry trade and a rising Yen.

It may be time to throw the theory out of the window, however, as the Yen began rallying weeks ago and is now placing pressure on short sellers at the highs put in place last August. A recent Commitment of Traders report showed that a number of futures trades of significant size have brought support to the Yen rally, and speculative traders are now at their most net long the currency since October 2012.

Ongoing US monetary policy will be the biggest determinant here. If interest rates are hiked further then this would tend to undermine the possibility of a Yen rally.

The Euro

Having rather put the brakes on the Dollar this last few weeks, the Euro has made repeated advances towards its recent highs. Just like the Yen, however, the Euro (along with the Swiss Franc) is a popular funding currency, and while ever Eurozone monetary policy is to continue to suppress interest rates, the currency’s long term upside is limited.

Thursday’s ECB announcement will be scrutinized for evidence of further stimulus in March, especially with inflation forecasts increasing at their current rate, and a risk-on atmosphere would certainly be supportive of this.

The British Pound

Sterling was largely in the hands of the sellers last week, after the Bank of England revealed a further split on interest rates. Caught between the opposing monetary policies of Draghi and Yellen, the strategy adopted by the UK’s central bank seems to be to sit it out and see how things develop over this first quarter.

There are a number of fundamentals that could drag the Pound still lower, including this week’s CPI figures, unemployment and wage data, and retail sales, but if a move to ‘risk-on’ and rallying equities creates a positive flurry in sentiment then the currency should start to find some support. Over a longer period, stronger equities markets could provide the stimulus needed for the Bank of England to follow the US’s suit and lift benchmark interest rates above their current all-time low.

Concluding Thoughts

Understanding how the many pieces of the macro-economic jigsaw puzzle fit together to influence currency trends and motivate the forex markets is never easy. Assuming that a shift in investor attitudes to risk will simply reverse current trends across the board is foolhardy, but preparing for unlikely outcomes and playing through the possible scenarios is an essential part of successful trading.

Whether or not the ideas discussed here are given the opportunity to play out over the coming week depends on a great many factors, but sooner or later the market conditions that have prevailed since the start of the year will come to an end, and a new direction will emerge.

About the Author

Alexander Pearson is an online financial journalist. He has contributed market analysis, industry news, and educational articles to a variety of sites including Seeking Alpha and OilPrice.com. His background is in quantitative trading and strategy development.

Alex’s main specialization is in the brokerage industry, and he is the editor of BestBrokerDeals.com, an online portal for broker promotions providing a wide range of tools and resources to research and compare discount brokerage firms.