Risk On/Risk Off Trade Is Dying Despite What Tape ShowsMichael P. Regan
It’s common for news organizations to prepare obituaries of famous people before they die. And, embarrassingly enough, sometimes the death notices are accidentally published while the subject is alive and well.
Nicholas Colas wrote an obituary for a famous trading trend today. “RIP: Risk On, Risk Off (2008-2014)” read the headline from the chief market strategist at ConvergEx Group. The trade he eulogized was the tendency for risky assets like stocks, as well as currencies and bonds of countries with shaky finances, to rise and fall together. Bets considered safe havens like Treasuries, German bunds, the dollar and yen tended to do the opposite of what the risky investments were doing as various crises came into and out of fashion over the years.
Looking at the tape today, however, the risk-off trade appears to be alive and well. Stocks in Europe and the U.S. are sliding, as are bonds in Portugal, Spain and Italy, while haven assets are jumping after everyone got spooked by a missed debt payment from the parent company of Banco Espirito Santo SA. So did Colas push the send button on his obituary too early?
“That certainly is the question of the hour,” he said in an e-mail today. “If the sell-off pops correlations higher, then it will be a signal that investors expect the Fed to bail them out again. My expectation is that prices will continue to move more independently than they did during 2008-2011.”
Setting aside today’s tape, the case that risk on/risk off is dead is fairly strong. Correlations -- the mathematical representation of how closely different asset prices move together in lock-step -- have fallen to new post-financial crisis lows for a range of asset classes, Colas wrote.
Here are some examples from his report. The average 30-day correlation of the 10 main industries in the Standard & Poor’s 500 Index is 68.7 percent, compared with 95 percent in parts of 2011. Correlations of the Australian dollar and euro to U.S. stocks are near zero, and the synchronized moves of overseas developed-market equities to the U.S. are also lower.
He offers a good news/bad news scenario to the death of this trend. The good news for stock pickers: “Assets price increasingly on perceptions of fundamentals rather than central bank policy,” Colas wrote. And the bad: “This is the final stage of the bull market. Cue the locusts.”
Bespoke Investment Group LLC also weighed in on correlations yesterday, pointing out a “major shift” in the six-month link between the S&P 500 and U.S. Treasury Long Bond futures. Last fall the correlation was negative, meaning the two moved in opposite directions, which is what you would expect in a risk on/risk off regime. Now, the correlation is a positive 60 percent, meaning the two haven’t been this much in sync since 2007, according to Bespoke.
There’s a word for the type of call Colas made today: risky. But run the charts yourself and you may agree: It’s too early to publish the obituary for his pronouncement.