Correlations between the dollar and equity markets have shifted yet again; Marc Chandler provides an analysis on one of the most important themes in the first quarter.
The divergence meme that had the US well ahead in the global business cycle produced a virtuous cycle. The dollar and US stocks rallied together. However, with the dollar’s appreciation spurring concern about US corporate earnings, and the negative interest rates in Europe spurring flows into equities, correlations between the dollar and equity markets have shifted again and that is one of the important themes here in Q1.
The implication of these shifting correlations is not just important for hedging decisions, but also reflects changing drivers. First, the outperformance of US shares last year opened a large divergence in valuation with European equities. This gap has been closed now, or nearly so. Second, the sharp rise in the dollar hurt the translation of foreign sales into dollars for accounting purposes. Third, deflation and the ECB’s policy response have created a powerful incentive to move into European equities. A significant fraction of European bonds have negative yields. Foreign investors have been significant buyers of European equities. During some weeks, the flow of funds out of US equity funds into European equity funds matched up almost dollar for dollar.
As investors, we are interested in the correlation of returns. This can be approximated by running the analysis on the basis of percentage change. This is more robust than monitoring levels and cannot simply be eyeballed. We look at the 60 and 90 day correlations.
From last October through earlier this month, the 60 and 90-day correlation between the S&P 500 and the euro were inversely correlated. That is to say, the dollar’s pace of appreciation against the euro was correlated with the pace of the S&P gains.
This changed earlier this month. The euro and the S&P are now positively correlated (percentage change). The 90-day correlation stands at 0.1. At the end of last year, it was at -0.32. The 60-day correlation is at 0.35 compared with -0.34 at the end of 2014.
The euro remains negatively correlated with the Dow Jones Stoxx 600. The 60 and 90-day correlations are near -0.31. At the end of last year, the correlations were closer to -0.50.
Sterling’s correlation with the S&P 500 also has reversed. On a 60-day basis, it was mostly flat in the early part of Q4 14, but turned clearly negative before the end of 2014, reaching -0.23 in January. It has recovered from the middle of the month, and today is near 0.30, the highest in nearly a year. The general pattern of the 90-day correlation is similar.
Sterling’s correlation with the FTSE has been even more dramatic. The 60-day correlation was negative through Q4 14, falling to -0.40 in December. It has gradually trended higher since, reaching almost 0.14 last week. The 90-day correlation has turned positive in the middle of March and today it is near 0.08.
Meanwhile, it is interesting to note that sterling has become more correlated with the euro. Last September the 60-day correlation had fallen to nearly zero, but it has recovered and today is near 0.78. Rarely over the past five years has the correlation moved above 0.80. The 90-day correlation has also rarely been above 0.80 and today is near 0.74.
As the business cycles have come more disconnected, the correlation between the S&P 500 and the Dow Jones Stoxx 600 has generally trended lower. The multi-year peak (60-day percent change basis) was near 0.87 in 2012. It trended lower through early last year when the correlation dipped below 0.40. It had bounced to almost 0.67 at the start of 2015, but has slumped back to near 0.40 and now stands at 0.48.
The percent change in the dollar-yen rate remains positively correlated with the percent change in the S&P 500 but has diminished. Last March the 60-day correlation was near 0.80, and now it is at 0.31. The 90-day correlation peaked near 0.70 and now is just above 0.40. The low point was reached last September in the 0.16-0.17 for both.
The dollar-yen’s correlation with the Nikkei has weakened. The 60-day correlation peaked at the start of the year near 0.43. It is now about half of that. The weakening relationship is even more pronounced in the 90-day period. The correlation today stands at just below 0.09. It peaked in late January near 0.50.
Recall that the BOJ’s quantitative easing includes the purchases of Japanese equities through ETFs. In addition, Japanese pension funds, most notably GPIF, have been diversifying investments away from Japanese government bonds toward domestic equities and foreign assets.