MBS Day Ahead: Risk-on, Risk-off: One Trading Rule Every Market

When the variables informing trading decisions are more confusing, more diverse, and/or more numerous than normal, there's one old standby to fall back on: the risk-on/risk-off trade!  The rules are simple:

1. Find a variable in the marketplace... any variable!  The more that other people seem to be talking about it, the better.

2. The variable can even be the price of another security.

3. Decide if the variable suggests risk-taking, or risk aversion

4. Find any security you can get your hands on (or that you already own) and trade it in the direction of the risk!

5. Profit.

For a mainstream example, let's take yesterday's Retail Sales data.  Stronger sales fuel risk appetite, suggesting selling bonds or buying stocks or both.  Of course that's a pretty typical reaction when it comes to economic data.  What about something more complex, like when the variable is another security?

This is currently playing out with oil, where the slide in prices has become increasingly worrisome to markets.  Yes, lower oil prices are like a tax cut for the American consumer, but surely such a big fast drop must be bad for some reason (that sounds bit tongue-in-cheek, but I'm being serious, and markets seriously feel this way for several reasons).  So when oil falls, the trading response is simple: buy bonds, sell stocks, etc.

Between oil, European bond markets, European stock markets, synthetic risk indices like the .VIX, Treasuries, Stocks, Oil Prices, Eurodollars, other currencies, and whatever else, there is plenty of risk-on/risk-off trading to be done, and this has definitely been a week for that!  To prove the point, here's a chart of 5 different securities.  They're not labeled because it doesn't matter what they are (all major markets though).  While the correlations don't line up from moment to moment in a perfect way, they all started at the upper left of the chart on Monday and are ending the week on the lower right.  

This trend will reverse at some point--maybe even today--because
risk-off trading is a finite thing.  When it does--even if it's just a
periodic correction--MBS will lose ground.  Again, this is a hungry
rally.  Without this ongoing diet of stock/oil/Europe weakness, bond
markets are ready to take a breather.