The Role of Investor’s Risk Appetite in Market Prices

Markets are constantly influenced by geopolitical events, particularly those that carry the potential to disrupt global economic stability. The recent geopolitical tensions in the Russian / Ukrainian war and the middle eastern instability are clear illustration of how risk-on and risk-off market dynamics can shift rapidly in response to geopolitical tensions.

What Is Risk-On / Risk-Off?

“Risk-on” and “risk-off” refer to the market’s appetite for risk.

In a risk-on environment, investors are generally optimistic and more inclined to invest in higher-risk assets such as equities, high-yield bonds, and risk-sensitive currencies like the Canadian Dollar (CAD) and the Australian Dollar (AUD). These currencies are often positively correlated with global commodity prices, including oil, minerals, and agricultural products.

Conversely, a risk-off sentiment drives investors toward safer assets like US Treasuries, gold, the US dollar, and the Japanese yen, as they seek to preserve capital during uncertain times.

Geopolitical Escalation: A Trigger for Risk-Off

Any direct exchange of hostilities between countries is marked a significant moment, such as the Middle East tensions. Key risk-off reactions may include:

• A surge in gold prices due to increased demand for safe-haven assets.
• A spike in oil prices is driven by fears of a broader regional conflict that could threaten shipping through the Strait of Hormuz (a vital passage for global crude supplies).
• A pullback in equities within developed markets, particularly in sectors sensitive to geopolitical risk, such as airlines, travel, and global trade.
• A drop in the US Treasury yields as demand for low-risk government bonds rises sharply.
• A rally in the Japanese yen and Swiss franc, reflecting their traditional role as safe-haven currencies during geopolitical turmoil.

Risk-On Resilience After De-Escalation

Any signals of de-escalation and reports indicated successful mediation efforts by global powers like the U.S., China, and the EU, the markets may quickly reverse course. With no immediate follow-up to military operations, risk-on sentiment returned, albeit cautiously.

Markets would resume their focus on macroeconomic data, such as U.S. inflation readings and central bank policy decisions, with equities rebounding and volatility indices like the VIX retreating from post-conflict highs.

Conclusion

The risk-on/risk-off dynamic provides a powerful framework for understanding financial markets, especially during periods of global tension. The recent Israel-Iran confrontation, while alarming, clearly demonstrated how quickly investor sentiment can shift in response to geopolitical developments. As tensions in the Middle East and other regions remain fluid, markets are likely to remain highly sensitive to any signs of escalation.