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Capital Markets: Three Key Shifts in Correlations and What They Mean


Correlations are shifting between the euro and the pound sterling, the euro and the Australian dollar, and gold and the S&P 500.

Correlations in the capital markets often appear unstable and volatile. At times, different considerations are more salient than others, and this is reflected in the shifting correlations. But at the same time, this instability impacts investment decisions as well as hedging decisions.
There are three changes in the correlation patterns that I will bring to your attention: the euro and the pound sterling, the euro and the Australian dollar, and gold and the S&P 500 (INDEXSP:.INX). As a quick methodological note, I am more interested in the correlations of returns than the correlation of two time series. Therefore, we conduct the correlations on percentage change rather than level.

Euro-Pound Sterling: The correlation between the euro and the pound sterling has broken down. On a 60-day and 90-day rolling basis, the correlation is the lowest since 2000 at 0.21 and 0.34 respectively. Rarely has the 60-day correlation fallen below 0.40 since the advent of the euro and rarely has the 90-day correlation fallen below 0.50.
The 60-day correlation was fairly stable most of last year, even as the European Monetary Union debt crisis ebbed and flowed. The breakdown began in January 2013 as the pound sterling sold off while the euro did not peak until early February. The correlation spent February and March mostly between 0.25-0.30 correlation, before slipping in early April as the pound sterling was carving out a bottom, while new pressures weighed on the euro.
Initially the weaker correlation coincided with a jump in implied volatility. The benchmark 3-month implied volatility jumped from 5.3% in early January to 9.5% by late February. It has been trending down during March and early April to stand near 6.8% today, which represents nearly two-and-a-half month lows.
Euro-Australian dollar: The correlation between the euro and the Australian dollar has also broken down. The 60-day and 90-day correlations are near their lowest levels since late 2002/early 2003 at 0.19 and 0.26 respectively. Rarely has the 60-day correlation fallen below 0.35 during the past decade, and the 90-day correlation has not been below 0.40 until now.
The Australian dollar rallied in March as the euro sold off. Comments from the Reserve Bank of Australia and somewhat better-than-expected data saw the Aussie dollar rally from near $1.01 in early March to $1.05 by the end of the month and retested in early April. For its part, the euro trended lower from early February's test on $1.37 to $1.2750 in late March and again last week. The grab for yield that has greeted the Bank of Japan's announcement and has fueled dramatic rallies in European bonds not gone unnoticed in Australia, where the 10-year yield is off 9 bp today and roughly 20 bp since the Bank of Japan's decision last week. However, the Aussie itself is slightly softer with three-week lows set earlier today.
The euro recovered against the Australian dollar, moving from near A$1.22 in the middle of last week to the A$1.2550 before the weekend and rested it today. It is just shy of a retracement objective of the euro's slide that began near A$1.32 in early February, which comes in just below A$1.26. If this area is successfully breached, the next retracement objectives are found near A$1.27 and A$1.2820. The price action is not very inspiring -- the 5-day moving average is poised to cross above the 20-day moving averga efor the first time since February 19. Support is seen near A$1.2400.
Gold and the S&P 500: The unorthodox easing by the major central banks and the initial attempt to bail in insured depositors was widely thought to underpin gold prices. The price of gold is off about 9.5% this year in dollar terms. Indeed, it has been trending lower since early October 2012's test on $1800 per ounce.
In contrast, the S&P 500 has been trending higher since the last correction ended in mid-November. It has moved within spitting distance of the October 2007 record high of 1576. Hence, the correlation between the two has broken down. On a 60-day basis, the correlation is slightly negative now, while the 90-day correlation is barely above zero.
The stronger the correlation between gold and the S&P 500, the more gold will trade like an asset. When the correlation is inverse, gold arguably acts like a safe haven. Since the financial crisis began, the 60-day and 90-day correlations have mostly been positive, but nearly ever year, there is a period of inverse correlations. Last year was an exception for the 90-day correlation, which never became inverse.
The longest inversion since the crisis began was from April 2008 through November 2008, which is when the 90-day correlation reached just beyond -0.5. From late 1998 through 2003, the 90-day correlation was rarely positive.
The weak correlation between gold and the S&P 500 suggests that gold is acting more like a safe haven now than at any time since last June. The problem for gold bulls seems to be that the liquidity being provided by the major central banks -- or the liquidity that is anticipated -- means that investors are being forced out of safe havens.

See more from Marc Chandler at his blog Marc to Market.

Twitter: @marcmakingsense
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