Correlation Breakdown

A Glimmer of Hope for Macro Hedge Funds

The era of central bank distortion of market prices may be ending.
Nicholas Kamm/AFP/Getty Images

In recent years, hedge funds pursuing the style known as global macro have underperformed their peers. Shifts in the foreign exchange market, though, may presage the arrival of an environment less hostile to their investment technique.

Bottom of the Class

Global macro has lagged other hedge-fund investing styles

Source: Eurekahedge via Bloomberg

Note: Returns calculated to end-2017

The dollar is near its weakest against the euro in more than three years. The U.S. currency has been on a wild ride in recent trading sessions, buffeted by perceived U.S. trade-war threats that prompted a stinging rebuke from the European Central Bank. Its moves this month have been sufficiently violent to drive volatility in the currency market up from its lowest in more than three years.

Volatility Revived

The dollar's recent swings have spurred volatility higher

Source: Deutsche Bank's FX Volatility Index via Bloomberg

The bond market is also posting more agitated prices moves; Merrill Lynch's MOVE index of U.S. fixed-income volatility bottomed at a record 44 points on Nov 8, and has edged higher to a three-month high of 56 points this week. It's harder for hedge funds to make money when prices are flatlining, so the return of volatility should provide some relief.

It's the backdrop to the dollar's recent weakness since the end of last year, however, that offers a glimpse of hope that the era of central banks distorting market prices may be drawing to a close.

Source: Bloomberg

Forgive, if you will, the crime of using two different indexes in the chart above. It illustrates how the relationship between interest rates and the currency market broke down at the start of last year.  

Between the start of the decade and the end of 2016, the correlation between the dollar's value and the gap between two-year U.S. and euro zone swap rates was an impressive 0.74 percent (where a value of 1 signals two price series moving in lockstep, while zero indicates a random relationship).

Put another way, as the gap between lower euro interest rates and higher U.S. rates widened, the dollar rose and the euro declined -- which is what you'd expect to happen.

Since the start of 2017, though, the correlation has broken to below 0.5 percent. Even as the interest rate gap has continued to widen as U.S. rates have risen, the dollar has dropped.

Why has that happened? How did "a relationship that FX strategists swore by for years" according to Gaurav Saroliya, the director of global macro strategy at research firm Oxford Economics, turn so dysfunctional?

Traders and investors have driven the dollar lower and the euro higher in reaction to the brightening economic outlook in the euro zone. The currency market has reacted to the underlying fundamentals rather than monetary policy.

Catching Up

The consensus forecasts for GDP growth this year show a narrowing gap

Source: Bloomberg's ECFC function

The interest-rate market, meantime, has been dominated by the ECB's quantitative easing program and its parallel negative interest rate policy. In short, while the two-year dollar rate spent last year racing to almost 2 percent from about 1.2 percent in January, the two-year euro rate ended 2017 at about minus 0.6 percent, roughly where it started the year.

That's starting to change. So far this year, the two-year German yield has climbed about 10 basis points to minus 0.52 percent; on Monday, the five-year yield turned positive for the first time since December 2015. And the benchmark 10-year yield rose to within a whisker of 0.7 percent compared with its 2017 average of 0.38 percent.

The ECB is poised to take its foot off the collective throat of the interest-rate market by ending QE, perhaps as early as September. Euro-denominated bond yields are starting to reflect economic reality -- much as the currency market has already done. It's a backdrop against which global macro funds should be able to rediscover their mojo.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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