Global markets caught in a correlation breakdown

February 2, 2017 10:40 am

Business charts and markets. (Image: Alamy)

* Morgan Stanley correlation index hits 14-year low

* Regional, cross-asset correlations all down sharply

* Trend highlights shift in focus away from central bank policy

 

Financial asset prices are moving in step less than at any time in more than a decade, as economic and monetary policies diverge and political risks grow around the world.

Unusually loose central bank policy after the global financial crisis drove so-called cross-asset correlations to record highs, meaning prices of stocks and government bonds often moved in tandem in the “risk-on, risk-off” environment that dominated financial markets.

Now, with the US Federal Reserve raising interest rates while other major central banks keep their policy loose, those links are breaking down.

Lack of correlation between prices is important for investors who try to avoid having all assets in their portfolios falling at the same time, seeking to offset losses in one through gains elsewhere.

Morgan Stanley identifies another factor contributing to the break-down: confidence in a global economic recovery reduces the chances that markets will panic at the same time. Instead, market-specific stories become more important than binary issues such as whether or not there will be a recession.

The bank’s Global Correlation Index, has fallen to just 20 per cent – its lowest level since 2003.

 

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The index reflects how closely prices of currencies, bond spreads and major equity markets across the world are moving relative to each other. It also incorporates correlations between regional markets.

“In just four months, we have gone from a market of unusually close linkages across markets, to one with unusually divergent returns,” Morgan Stanley said in a note.

It also said hedging strategies that have worked in recent years may no longer be effective.

 

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Worsening economic situation

While investors might have hedged against a worsening economic situation in the euro zone by buying bonds, stocks or the euro, that may no longer be the case.

Cosimo Marasciulo, head of European fixed income at Pioneer Investments, said the correlation collapse shows central banks have ceased to be the drivers of asset prices as focus turns from monetary policy to fiscal policy.

“Coupled with an increasingly uncertain geopolitical backdrop, the possibility for idiosyncratic risk has increased,” he said in a note, pointing to events such as looming elections in France or Britain’s Supreme Court ruling on Brexit.

 

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One market in which this divergence has played out is the bond market, where U.S. Treasury yields have risen in “reflation” trades since Donald Trump’s election in November.

Bond yields in Europe have also risen, but the move has been capped by the European Central Bank’s bond-buying stimulus and as rising political risks in countries such as France and Italy supports demand for safe-haven German debt.

Marasciulo said the correlation between 10-year U.S. Treasuries and German peers has fallen from over 0.90 in early 2016 to 0.52 now.

 

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