The British currency rose against the US dollar and the euro, after the return of investor confidence. With the recovery of major stock markets, investor risk appetite returned helping boost currencies such as the pound which are closely influenced by global market sentiment. The pound is considered a risk currency and is vulnerable to risk-off sentiment at times of risk-on.
Major concerns such as the Delta variant and the Fed’s removal of its stimulus programme will be the main drivers for global currencies such as Sterling. While there is still significant uncertainty about how the delta variant will affect markets, most developed economies are expected to grow steadily. Nonetheless, Sterling will remain sensitive to global developments than domestic economic data, as the economic calendar is thin with releases of little impact.
Risk on and Risk off sentiment
The widespread risk on and risk off sentiment, also known as RORO is the major driver of currencies in the market at the moment. Two of the key concerns of global investors are the withdrawal of the Federal Reserve’s stimulus and the rapid spread of the Delta variant in Asia.
But what is exactly risk sentiment? Simply, risk-on risk-off refers to shifts in investment activity as a result of global economic events. The foreign exchange market is basically affected by changes in the ways investors behave and where they choose to invest. The theory states that investors engage in higher risk trades when the risk is considered low and avoid high-risk investments when the risk is perceived to be high. So, investor appetite changes depending on global sentiment and whether risk is high or low. For example, the 2008 financial crisis was considered a risk-off year, as investors avoided risk by selling their risky assets and turning towards low or no risk positions such as U.S. Treasury bonds.
The risk-on risk-off sentiment is also affected by different asset classes, as some carry higher risks. Stocks are riskier than bonds and so when stocks are preferred more than bonds then the market is considered a risk-on environment. A risk-on environment is one where investors invest into riskier assets.
A risk-on environment is usually one where a combination of positive economic factors, data and events co-exists, showing that the market is healthy and strong, and risk is limited. Strong economic data such as corporate earnings, an optimistic outlook, and supportive central bank policies reflect a market where investors have more room to take on more risk.
Federal Reserve and monetary stimulus
In the coming week, the fundamental concern for markets will be the Federal Reserve's decision to withdraw monetary stimulus. On Thursday, Federal Reserve Chair Jerome Powell will give a speech at the Jackson Hole central banking symposium and investors expect him to announce the Fed is ready to start reducing stimulus, possibly as soon as this September. While this is good news for the US dollar, stock markets which have been supported by the Fed’s funding will find the news disappointing. This will also affect the British pound which could fall following such an announcement. For some analysts, Powell might avoid bringing up monetary policy at the symposium, but others believe that the dollar will weaken if the Fed postpones the planned withdrawal of its funding.
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