Risk-on risk-off

A description of episodes in which one factor dominates almost everything at once. In the risk-on state, equities, higher yielding currencies, industrially used commodities and lower rated credit tend to rise together. In the risk-off state, the flow reverses towards government bonds, gold and the currencies habitually treated as defensive, among them the dollar, the yen and the Swiss franc. Membership of either bloc is a market habit that has shifted over time rather than a property of the assets.

The mechanism claimed for it is a common factor, usually described as global risk appetite or funding conditions, temporarily overwhelming the drivers particular to each market. It is observed as a rise in average pairwise correlation: assets that normally have little to do with each other begin moving on the same news at the same time, and the amount of a portfolio's variation explained by one factor rises sharply.

The consequence that matters is for diversification, and it is unwelcome. A regime of this kind arrives precisely when correlations were being relied on to be low, so holdings assembled to be independent behave as one position at the moment that independence was supposed to help. The framework is also a description applied afterwards rather than a rule: the classifications change, currencies have moved between the blocs as their rate differentials moved, and practitioners disagree about whether the pattern has weakened since the years after the financial crisis in which the phrase was coined.