Asset Contagion Worse Than 2008 as Markets Held Hostage to Rates

  • Treasuries, corporate bonds exerted big influence on others
  • JPMorgan analyst warns of violent unwind of correlations

Memo to macro money managers who sense that diversifying funds is harder than ever: you’re not imagining things.

Consider a Credit Suisse Group AG gauge known as the cross-market contagion indicator, which tracks price relationships in equities, credit, currencies and commodities. It shows that different markets are influencing each other in 2016 at a higher rate that any time since the measure was invented in 2008. The indicator assesses how much movements in one market are statistically explained by movements in another.

The data illustrate the interconnections among global markets and may reflect the growing impact of central bank policy on prices. An increase in correlations is fodder for skeptics who look at declining U.S. earnings and rising valuations and argue that the only explanation for record highs in U.S. stocks this summer is Federal Reserve policy.

“Rates are driving everything,” Mark Connors, Credit Suisse’s global head of risk advisory in New York, said by phone. “At a minimum you have to be aware of the influence of central banks. What’s moving the market is people’s demand for yield and return. Fundamental analysis doesn’t explain the movement higher from here.”

Credit Suisse keeps track of the performance of various assets through 21 exchange-traded funds and employs a model called principal component analysis to define the degree to which markets are influencing each other. Its contagion index reached a record 75 percent  in late June after the U.K. decision to exit the European Union.

While the gauge has since slipped, it’s still averaged 65 percent this year, climbing for a second year after bottoming at 57 percent in 2014. Treasury and investment-grade bonds, securities mostly sensitive to fluctuations in interest rates, have been the highest-influence asset classes in 2016.

The elevated level of cross-asset correlations highlights the danger of simultaneous selloffs should central banks tighten. But what’s more troubling is the potential for violent swings in the inter-market relationship that could make it harder for quantitative funds to adjust, according to Marko Kolanovic, the New York-based head of global quantitative and derivative strategy at JPMorgan Chase & Co.

Computerized traders whose behavior is triggered by market signals like volatility or price trends rather than earnings or the economy have been contending with record fluctuations in cross-asset relationships. For instance, the correlation between the euro/dollar and the S&P 500 500 Index jumped to 75 percent when the U.K. voted to secede, and has since reversed to minus 60 percent, data from JPMorgan showed. The average stock correlation plunged to only 10 percent in August after exceeding 70 percent earlier.

“These record swings in the levels of cross-asset correlation point to a high level of macro uncertainty which makes asset allocation difficult,” Kolanovic wrote in a note to clients Wednesday. “This large instability of correlations makes it harder to forecast and hedge risk for a multi-asset portfolio and strategies such as risk parity.”

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