Tuesday, 24 February 2009

Inter-market correlations and strategies are morphing

A number of previously reliable inter-market correlations are starting to break down. Not only does yen strength no longer appear to be positively correlated with US equity weakness, in fact the converse or negative correlation is establishing itself. Yet another example is the normal inverse correlation between the spot price of gold and the strength of the US dollar. There has been a well documented tendency for strength/weakness in these two asset classes to move in a counter cyclical manner but there is mounting evidence to suggest that the relationship is transforming itself into one with a more positive correlation.

One could even cite the fact that during the decline in the equity markets over the last several weeks, US long term Treasuries are not demonstrating their more typical safe haven status as yields are no longer so readily moving inversely to the direction of prices in the broad equity market.
Could it be that these correlations are weakening, and in some instances going into reverse, exactly because the inter-market co-movements which were historically observed, and then used as a foundation stone for a variety of cross-asset trading strategies, are not being practiced by hedge funds to anything like the same extent today as they have been in recent years?
The fact that the correlations are morphing because of the declining role of the hedge funds will of course mutually reinforce the changes in such correlations and could make trading conditions even more unpredictable for funds that are using top-down quantitative strategies that attempt to exploit arbitrage opportunities between different asset classes.

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