Risk On, Risk Off

One cycle that dominated the markets this year was the “risk-on, risk-off” cycle. With the continuation of the Fed’s zero interest rate policy, the U.S. Treasury market certainly wasn’t driven by rate changes in 2012. Instead, waves of fear shuttled investors into the perceived safety of U.S. T-bonds.

The market’s fears were many … a disorderly breakup of the euro … China’s growth grinding to a halt … a collapse of the Japanese bond market … and a collapse of the Canadian housing market.

Regardless of the specific concernrn, the bond market bobbed up and down this year in waves of rising and receding fear.

Here’s a chart of the VIX in white, and 10-year U.S. Treasury bond futures in green.

These markets correlate for good reason. The VIX is a measure of expected volatility.

See larger image

Generally, when the VIX increases, it indicates the market is nervous or fearful. All it takes is a few days of gloomy headlines out of Europe, or bad numbers out of China, for the VIX to spike higher.

Meanwhile, 10-year Treasury bond prices tend to move in line with the VIX. As the market gets nervous, investors shift funds into safe havens, like T-bonds. This makes the price of T-bond futures go up.

As you can see in the chart above, T-bond futures and the VIX peak in sync with each other. For most of this year, this “risk-on, risk-off” cycle has peaked about once every one to two months.

Watching these two markets move together helps me gauge the overall mood of the stock market. Like most things, market sentiment moves in waves. It helps to keep the momentum at your back.

Right now, the stock market is in risk-off mode, with both the VIX and T-bond futures moving higher, so we should be cautious. But, the dip in equities should give us some good buying opportunities in early 2013.

If you haven’t done so already read the Survive & Prosper issue on “Demography is Destiny.