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The Virus Strikes Back

Financial markets opened on a weak note in what was supposed to be a quiet and slow trading week. However, this is not your regular Christmas trading week, just like 2020 is not a regular year. 

The COVID-19 virus mutates, and it appears to spread faster. The news coming out of the United Kingdom over the weekend that the new variant spreads much faster than the previous one made several countries ban UK flights.

Under such conditions, financial markets are the first ones to react. The danger of a coordinated risk-off market event is real, especially considering the low liquidity environment typical for this time of the year.

Risk-Off in Financial Markets

The first thing to see in a risk-off event is the stock market going down. Therefore, all eyes are on the United States stock market, as it remains the largest in the world. Futures so far are sliding, and with them, the dollar, the world’s reserve currency, is soaring.

This is the most important correlation to consider in a risk-off event. The flight to safety typically implies stronger safe-haven currencies, like stronger JPY and CHF, but in a real risk-off event, funds flow to the dollar.

At last Friday’s closing, the dollar suffered across the board. However, the risk here is for a major reversal, a reversal that threatens to disrupt the markets. Not even the fiscal stimulus discussions in the United States cannot stop a risk-off, coordinated market move.

What to expect in a risk-off environment besides lower stocks and a higher dollar? Depending on the amplitude of the move, the fall may trigger reactions in other markets, too – e.g., commodities.

In the currency market, a risk-off event means lower EURUSD, AUDUSD, GBPUSD, and higher USDCAD. At the same time, the higher dollar triggers a move lower in gold and oil as well.

After the meltdown in March, the central banks’ efforts paid off. The Fed opened USD swap lines with other central banks in the world and injected dollars into the financial system. As such, the stock market recovered, and, with it, it initiated a risk-on move – the opposite of everything described here.

Because we are at the end of the trading year, the end of the year flows can also amplify a possible risk-off move. Expect the days ahead to be crucial for the year’s performance.

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