In the wake of escalating geopolitical tensions and trade policy uncertainties, global financial markets are experiencing increased volatility.

This unpredictable landscape prompts a critical need for understanding investor sentiment, which is essential for central banks in shaping monetary policy.

Investors' willingness to assume risk reflects their outlook on future economic conditions and the uncertainties they associate with it, and can lead to significant macroeconomic implications.

A new risk appetite indicator has been introduced to systematically assess these shifts in market sentiment within the euro area, providing a comprehensive tool that reflects both periods of market optimism, labeled 'risk-on', and caution, termed 'risk-off'.

This indicator builds on established methodologies that utilize principal component analysis to consolidate information from various financial asset prices into a coherent daily gauge of market sentiment.

To construct this euro area risk appetite indicator, ten financial variables were considered, including major equity indices, volatility indices, sovereign and corporate bond spreads, as well as exchange rates.

This approach aims to avoid overemphasizing fluctuations from isolated asset classes or indicators, allowing a more nuanced understanding of overall market mood.

The resulting risk appetite index, which reflects daily changes in market sentiment, illustrates significant correlations with economic events.

Historical observations demonstrate that in times of high stress, investor risk appetite diminishes, whereas periods of optimism correlate with increased risk-taking.

Recent examples include fluctuations in sentiment following announcements related to US tariffs and euro area political events.

Monitoring significant changes in risk appetite can also shed light on broader economic trends.

Recent observations indicate a slight increase in net risk appetite in the euro area in early 2025. However, this overall increase masks underlying volatility, with notable declines associated with trade-related uncertainties, followed by rebounds influenced by more favorable news.

Analysis of past financial crises, such as the global financial crisis and the euro area sovereign debt crisis, demonstrates the importance of regional distinctions in investor sentiment.

During both crises, declines in risk appetite were evident in both the euro area and the United States, but the impacts were felt differently across the regions due to distinct economic conditions and events.

The risk appetite indicator serves as a valuable tool for central banks, offering a means to monitor and interpret the ever-changing mood of investors in real-time, thus aiding in economic forecasting and policy formulation.