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Risk On, Risk Off and an Increasingly Correlated Market

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Risk On, Risk Off and an Increasingly Correlated MarketThe fears and uncertainties of the financial crises in 2008 began a new way of thinking when it comes to trading.  Institutional investors began using a new trading system called “risk on, risk off”.  Essentially, when inflation is heating up that is when you are using “risk on” tactics and when there is deflation on the Street, use “risk off”. In-fact, UBS recently launched two ETns to ‘play the trade’; ETRACS Fisher-Gartman Risk On ETN (NYSE:ONN) ETRACS Fisher-Gartman Risk Off ETN (NYSE:OFF), we warn investors to avoid these products.

“Risk on” has a variety of possible trades that would fit the bill.  Some examples are long stocks, commodity currencies, energy & food commodities.  However, you could also short bonds, non-commodity currencies.  SPDR Barclays Capital High Yield Bnd ETF (NYSEARCA:JNK) would get hit hard because junk bonds tend to get hit hard when inflation increases.  This will help you protect yourself from any inflation that creeps up.  Luckily, inflation has been relatively minor and not a huge threat to the US economy in recent years.

“Risk off” has similar trades that would work but in a deflationary environment.  If there is deflation in the market, the “risk off” trades says to go long in reliable bonds such as US Treasuries and non-commodity currencies.  Conversely, you could also short stocks, commodities and commodity currencies.  If deflation begins to increase then commodities will get killed.  Commodity ETFs such as  PowerShares DB Com Indx Trckng Fund ETF (NYSEARCA:DBC) will get killed, along with others.  When deflation hits, assets get devalued and commodities are known for getting hit hard during these times.

The problem with the “risk on, risk off” trade is that it captivated quite a following back in 2008 and even since then that it has caused volatility to rise over the years and greater asset correlation.  The fact that big money managers have been getting in and out of assets with large sums of money has caused some asset classes to be highly correlated.  For example, since 2008 stocks, commodities, gold, oil and agriculture have become highly correlated in some way.

As a smaller investor, it would be in our benefit to know what the institutional money managers are trading in the risk on, risk off scenario.  The best way to determine their thought process would be looking for signs of inflation and deflation.  A easy way to do this is by looking at 10 year Treasury Nominal Bond Rate and the 10 year Treasury Inflation Protected Securities yield (TIPS).  Obviously, if the TIPS yield rises to the higher end of the recent yields then inflation is in the air and big money will most likely be trading risk on.  However, this is not always the most reliable way of determining the inflation levels in the economy.

Smaller investors need to watch out for any unexpected volatility in their holdings when it comes to the “risk on, risk off” trade.  Institutional investors move fast and with a lot of capital making it devastating if you are on the wrong side.

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