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Blog Posts — June 10, 2020

The top 10 cross-asset correlations to watch

by Christoph Schon, CFA, CIPM

In many of our recent blog posts and webinars, we noted how the COVID-19 crisis had disrupted the long-established co-movements and interactions of major asset classes. Some flipped signs, many broke down, and a few remained remarkably stable. In this blog post, we take a look at some of the most notable asset-class pairs.

1. US dollar versus stocks: from risk asset to safe haven

In the three-and-a-half years since the US presidential election, the value of the US dollar had been mostly tied to perceived prospects for the American economy. Much of the latter was influenced by the trade dispute between China and the United States. The greenback appreciated alongside share prices when progress was made toward a deal, and both fell whenever new import tariffs were introduced. Even as the coronavirus spread early this year, global stock markets continued their ascent in anticipation of the upcoming “phase one” trade agreement between the world’s two largest economies.

Year-to-date returns US equities versus dollar

Source: Qontigo

The figure above shows the year-to-date returns of the STOXX® USA 900 and the so-called Dollar Index, which measures the value of the US dollar against a weighted basket of foreign currencies. When share prices rose in the first five weeks of the year, the dollar appreciated alongside. Even during the initial stock-market selloff after the peak on February 19, the Dollar Index dropped nearly 5%, as equity investors lost 19% on average.

However, the interplay between the two made a 180-degree turn on March 9, as liquidity concerns led to a global rush on USD cash, as the greenback went from being a barometer for the state of the American economy to a safe-haven currency for investors from around the world. This meant that the dollar appreciated sharply, as share prices continued to fall, but then declined in value, when the USD positions were unwound, as risk appetites returned. This ensuing countermovement is illustrated through the inverted graph for the Dollar Index, represented by the dashed green line.

2. Yen versus US stocks: from hero to zero (correlation)

The Japanese yen is another currency that has customarily benefitted from falling share prices in the United States. Japanese investors are traditionally risk averse, repatriating their funds as soon as things take a turn for the worse in other parts of the world. This was reflected in the 9% appreciation of the yen between February 20 and March 9, visible in the chart below. It is worth noting that the USD/JPY exchange rate is quoted as yen per one dollar, which means that a decline in the time series signifies a strengthening of the former.

Japanese yen against US share prices

Source: Qontigo

These initial gains, however, were quickly erased once the US dollar took over as the world’s safe haven. The yen recently regained some of its risk-reducing properties, although this meant that it merely moved in line with its American counterpart. For US-based investors, USD/JPY appeared to be completely decoupled from the stock market. However, when viewed from a European perspective, for example, the yen would still have depreciated against the euro or the pound.

3. US Treasury yields versus stocks: to here and no further

As an economy starts to slow and investors withdraw their money from the stock market, ultra-safe government bonds are usually the main beneficiaries, as central banks lower short-term interest rates, while longer yields are driven down by the expectation of reduced economic activity and weaker consumer-price growth. These flows then reverse, once optimism and risk appetites return, and rates rise again alongside share prices.

10-year US Treasury yield versus US stock market

Source: Qontigo

During the initial stock-market sell-off, Treasury yields declined as expected, as market participants shifted funds into the relative safety of sovereign debt and the Federal Reserve Bank lowered its target range to 1.00%-1.25% on March 3. Yet, once the 10-year rate had gone down to 0.5%, investors seemed unwilling to accept investments that yielded less than Federal Funds at the time. This is in stark contrast to Europe, where the entire German Bund curve is now below zero, with maturities under 10 years offering expected returns of less than the European Central Bank deposit facility. Even the additional Fed rate cut to 0.00%-0.25% on March 15 had only a very limited impact of longer-term yields, which seemed to have settled just under 0.70%.

Since late-March, US Treasury yields had moved mostly sideways, and increased only recently to around 0.90%, following a surprise rise in non-farm payrolls announced in the week ending June 5. This indicates that bond investors seem considerably more cautious than their equity colleagues, not fully sharing the latter’s optimism on a swift economic recovery once the pandemic is over.

4. US equities versus credit spreads: strong and stable

The relationship between corporate-bond spreads and share prices is one that has been markedly stable and consistent throughout the entire crisis. The value of a company’s stock will normally be a function of its projected future earnings, whereas the size of its credit spread—as in the yield premium over a risk-free investment, such as a government bond or a swap—is more an indication of its ability to repay its debt—or not. While the two are often related, the strength of the interaction depends on the creditworthiness of the issuer. The more concerned investors are about a firm’s debt burden, the more the share prices will mirror those worries. As more and more countries and their economies went into forced lockdown and inactivity, and companies and households had to take on additional debt just to stay afloat, the relationship between those two indicators of economic health intensified.

US share prices versus USD corporate-bond spreads

Sources: Qontigo, Axioma Fixed Income Spread Curves

In the graph above, we show the average 5-year risk premium of North American issuers with a BBB rating over USD swaps. We specifically chose the lowest category in the investment-grade universe, as it was one of the most severely affected by the recent crisis, due to a surge of so-called fallen angels. When we overlay the spread time series with the inverted STOXX® USA 900—plotted against the right-hand scale—we see how closely the two have moved together. It is worth noting, however, that this does not necessarily imply causality in either direction, but could mean that both are driven by the same concerns about the growing levels of corporate, household and sovereign debt.

5. US Treasury yields versus credit spreads: no more compensations

The fact that Treasury yields bottomed out and then rebounded in early March—while credit spreads continued to rise alongside falling share prices—led to a decoupling of the previously inverse relationship between the two major drivers of corporate-bond risk and returns. This meant that the adverse effect of rising credit-risk premia was no longer attenuated by lower risk-free rates. This effect was particularly noticeable for securities with a higher credit rating, for which a further decline in sovereign yields would previously have offset, at least partly, the spread widening.

USD 5-year BBB credit spread versus 10-year US Treasury yield (inverted)

Sources: Qontigo, Axioma Fixed Income Spread Curves

More recently, longer Treasury yields have started to rise again, as optimism returned, but the expectation at the short end of the curve is still that low rates are here to stay for yet awhile.

6. Pound versus UK stocks: it’s no longer about Brexit…or is it at last?

Following the British EU referendum in June 2016, the interaction between the pound and UK blue-chip stocks, had been mostly opposite. Especially when the pound depreciated—usually after a setback in the Brexit negotiations—the share prices of large, international corporations would rise. The argument had been that a weaker exchange rate benefitted firms that derived a large part of their revenues from abroad. It also made UK assets appear relatively cheaper for foreign investors.

GBP/USD versus UK share prices

Source: Qontigo

As the chart above shows, the previously inverse relationship flipped signs with the onset of the stock-market selloff in late February. The reasons for this are two-fold in our view. Firstly, the newly regained safe-haven status of the US dollar meant that most other currencies—including the pound—would have depreciated in comparison since March 9. Secondly, the insistence of the British government on leaving the European Union by the end of the year, irrespective of the overall economic climate, has increased the perceived likelihood of a no-deal Brexit, putting additional downward pressure on the pound and making it the second worst-performing G10 currency year-to-date, after the Norwegian krone.

7. Norwegian krone versus oil: a risk combo

With the energy sector making up around 18% of Norway’s economy—and with oil accounting for more than 60% of the country’s exports—it is no wonder that the value of the Norwegian krone is closely linked to the price of the “black gold”. When demand for the commodity began to tumble as a result of economies going into lockdown around the world, NOK/USD dropped to its lowest level on record on March 20, down more than 20% in just two weeks.

NOK/USD versus oil price (Brent Crude – Europe)

Sources: FRED®, Qontigo

However, the strong connection with the oil price also meant that the krone has since recouped much of its recent losses, as demand for the commodity recovered. That said, the accompanying exchange-rate volatility has turned the NOK into the riskiest developed currency by a wide margin.

8. Oil versus stock market: an on/off relationship

The oil price has traditionally been highly correlated with the stock market, as both tend to be driven by global economic growth. However, there are also times when the relationship breaks down, usually due to geopolitical factors and/or other supply-and-demand considerations. Recent examples include Turkey’s threat to cut off Kurdish crude exports after the independence referendum in Iraq in September 2017 and the tensions between the US and Iran in June 2018, when oil prices spiked, while stock markets were spooked by the potential economic implications.

Oil price (West Texas Intermediate) versus US share prices

Sources: FRED®, Qontigo

In the current crisis, the disruption was caused by a presumed oversupply of oil, as the world’s major oil-producing countries could not agree on the necessary coordinated production cuts. A fear that there would not be sufficient storage capacity for the North American crude variety—West Texas Intermediate—even led to negative prices, as traders were prepared to pay buyers to take the excess supply off their hands. Prices have started to recover recently, alongside rising stock prices, but, as with bond yields, a return into negative territory seems to be no longer unthinkable.

9. Euro peripheral sovereign spreads: debt matters

The extensive fiscal rescue packages announced by governments around the world are likely to raise borrowing costs at some point, especially for those administrations that had been in a weaker financial position to begin with. Incidentally, those same countries, namely Spain and Italy, also happened to be at the epicenter of the European coronavirus outbreak. Both countries saw their 10-year yield premium over German Bunds rise by 80 basis points and 140 basis points, respectively, between the stock-market high in mid-February and the credit-spread peak in mid-March.

10-year sovereign spread over German Bunds

Source: Qontigo

It is interesting to note, however, that Spain’s risk premium did not rise as much as Italy’s, despite being hit similarly hard by the pandemic in terms of death toll and number of cases. This is in stark contrast to the Eurozone sovereign-debt crisis in 2011 and 2012, where the bonds of countries experienced similar markdowns. In our opinion, this reflects the fact that Spain today is in a much stronger fiscal position, both in comparison with 10 years ago and relative to its neighbor across the Tyrrhenian Sea. Similarly, in stress tests, which we performed frequently over the past months, Spanish bonds regularly showed much smaller simulated losses than their Italian counterparts.

10. Banks versus overall corporates: doom loop reloaded?

Closely tied to the development of sovereign spreads is the performance of banks, especially in European countries, where financial institutions tend to hold a large proportion of their domestic government’s debt. Therefore, any deterioration of the sovereign’s fiscal position is also likely to be reflected in bank balance sheets. This is exactly what happened during the Eurozone debt crisis in 2011/12, when the risk premium of global banks was around 150 basis points wider than the overall market average. The spread differential had reached similar heights in the global financial crisis of 2009, although the ‘toxic’ assets, weighing on the financial institutions then, were of a different kind.

Average 5-year spread for global banks and corporates issuing in USD

Source: Axioma Fixed Income Spread Curves

In the current crisis, bank spreads have thus far moved largely in line with the overall market, thanks to extensive central-bank support and loan guarantees from governments. That said, economies in Europe and the US are only just starting to come out of lockdown, and the full impact of the pandemic cannot yet be estimated. It is therefore worthwhile to keep an eye on this particular relationship. We certainly will.

For more information on cross-asset class correlations, view our Risk Monitor reports, or sign up for our weekly newsletters for regular updates.