The tendency of monetary policy to influence investors’ risk appetite has a significant impact on the effectiveness of the Eurosystem’s monetary policy on the macroeconomy and financial markets, according to an article in the latest Monthly Report. The authors analyse how Eurosystem monetary policy measures affect risk appetite in euro area financial markets – in other words, how willing investors are to take on risk. Their analysis is based on a new broad-based indicator of risk appetite in the euro area. 

The article provides empirical evidence of the relationships between monetary policy and risk appetite in financial markets from the Eurosystem’s perspective. Previous studies have focused primarily on the United States. 

Risk appetite in the euro area moves in line with the business cycle 

The authors find that investors’ risk appetite decreases in tandem with adverse macroeconomic developments and greater uncertainty. They cite the start of the COVID-19 pandemic as one such example. When risk appetite decreases, investors demand higher risk premia for holding the same quantity of risk associated with risky assets. In times of crisis, households accordingly shy away from exposure to risky assets in order to secure their desired level of consumption. Financial intermediaries can also become less open to risk. This is because crises lead to more frequent valuation losses, which in turn narrow financial intermediaries’ scope for borrowing or lending. 

Risk appetite in the euro area largely mirrors global developments

The analysis shows that the risk appetite index for the euro area mostly moves in line with the corresponding indices for US or global risk appetite. According to the economists, this suggests that, to a large extent, globally active investors determine risk appetite in the individual financial market segments of the euro area. 

However, euro area-specific developments, such as the European sovereign debt crisis from 2010 to 2012, have also had an impact on risk appetite in the euro area: “At that time, investors were concerned about the sustainability of government debt in some euro area member countries and the economic outlook for the euro area,” the report states. Risk appetite in the euro area fell significantly as a result, the authors write, contributing to European stocks and corporate bonds coming under greater pressure than those in the United States or at the global level.

Impact of monetary policy on risk appetite increases monetary policy transmission 

Turning to the effectiveness of the Eurosystem’s monetary policy, the authors find that the risk-taking channel of Eurosystem monetary policy strengthens monetary policy transmission in the euro area. The risk-taking channel is the mechanism through which monetary policy measures affect investors’ risk appetite. The analysis shows that an unexpected monetary policy tightening by the Eurosystem dampens the risk appetite of euro area investors, thereby increasing risk premia and thus amplifying the price decline of risky assets. 

At the same time, tighter monetary policy leads to an effective appreciation of the euro against the currencies of 18 trading partners. This reflects the fact that a wider interest rate differential causes foreign investors to increasingly seek out risk-free euro-denominated assets, the economists remark. However, the report goes on to explain that in the absence of an effective risk-taking channel the euro would appreciate more strongly. According to the authors, in the event of reduced risk appetite, globally active investors would increasingly shift to safe haven currencies and unwind positions in financing currencies for speculative carry-trade transactions, which would temper the appreciation of the euro.

Role of the risk-taking channel in the transatlantic transmission of monetary policy

The economists write that it is not just monetary policy impulses from the United States affecting the euro area. Monetary policy tightening by the Eurosystem also, albeit to a lesser extent, results in a “risk-off” movement in international financial markets. These are investment shifts from riskier assets to safer assets. Moreover, they continue, monetary policy tightening by the Eurosystem reduces risk appetite on both sides of the Atlantic. 

Risk appetite during key interest rate hikes between July 2022 and September 2023 

According to the authors, the monetary policy tightening cycle between July 2022 and September 2023 is likely to have dampened risk appetite when viewed in isolation. However, a rapidly improving economic environment is also shown to have supported investors’ risk appetite. As a result, risk premia rose less sharply than in the past, suggesting that the restrictive monetary policy impulses were not intensified by rising risk premia in individual financial market segments.