Don’t call it a panic.
Investors seem to be piling into traditional havens like Treasurys
and the Japanese yen this week. And stock-market volatility, as measured by the CBOE Volatility Index
widely known as Wall Street’s “fear gauge,” is at its highest since just after the U.S. presidential election in November.
But U.S. stocks, while looking shaky, haven’t seen an outright plunge. And other assets generally perceived as risky, including high-yield corporate debt and emerging market equities and bonds have held their own.
Kathleen Brooks, research director at City Index in London, argued that the phenomenon suggest the S&P 500
which on Wednesday closed below its 50-day moving average for the first time since November, isn’t having its usual impact on other asset prices. In a Wednesday note, she observed that the correlation between the benchmark stock index and other assets has weakened significantly since the beginning of the year.
“The fact that this is not happening suggests a couple of things: firstly, we are not in a period of market panic, and secondly, that any selloff in some risky assets such as U.S. stocks could be mild and may not signal contagion to other asset classes,” she wrote.
Among Brooks’s examples, the correlation between the S&P 500 and the dollar/yen pair
fell from 32% in January to 26% in April. Both are sensitive to risk sentiment, but the weaker correlations mean they move largely independent of each other, she noted.
The correlation between the S&P 500 and the spread between U.S. corporate junk-bond yields and U.S. Treasurys has also shifted. The correlation is usually negative. In other words, when the S&P 500 falls, the yield spread between junk and Treasurys usually widens as the price of the corporate debt also declines (bond prices and yields move in opposite directions). The correlation between the S&P 500 and the yield spread has turned positive. It was at 33% as of Wednesday, meaning that a third of the time when the S&P 500 falls, the spread tightens as corporate debt prices rise.
Brooks said the breakdown in correlations between the S&P 500 and other asset classes could mean that a jump by the VIX, which measures expectations for volatility over the coming 30 day period based on S&P 500 options, isn’t such a great gauge of fear on Wall Street and that a dip by the S&P 500 won’t necessarily translate into weakness for other asset classes.
But beware. Cross-asset correlations are showing some preliminary signs of reasserting themselves, noted Jeff deGraaf, chairman and head technical analyst at Renaissance Macro Research, in a Thursday note.
He points to the annotated chart below, which shows the average six-month correlation of a variety of risky assets. The correlation is certainly toward the low end of the long-term range but has started to turn higher:
The bigger picture, according to deGraaf, revolves around what a rebound in correlations might say about central bank liquidity as the Federal Reserve contemplates unwinding its balance sheet.
“It’s usually a reflection of a change in global liquidity and often central bank induced where correlations rise, returns go down and it pays to play defense,” he wrote. “We can’t help but wonder if the anxiety around the Fed’s balance sheet reduction is playing a role, and we’ll be monitoring it going forward as it’s still well below historically elevated levels that have signified liquidity events in the past.”