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 Tuesday 23 February 2016

PM Bulletin: Crude oil, yen and equities

 

 

Financial markets typically go through long phases when one asset class correlates closely (whether positively or negatively) with another. Many years ago, for a time, there was a near-perfect inverse correlation between equities and US Treasuries. When risk appetite was increasing, equities would rally while T-bonds would sell off. When investors were nervous they would bail out of equities and pile into fixed income. US government bonds were viewed as the ultimate safe-haven and so somewhat surplus to requirements when better returns could be had from equities, and vice versa. But that was a different world when it was possible to get a decent return from cash in the bank – perhaps not enough to beat inflation, but a return nonetheless.

More recently, stock indices and bonds enjoyed a strong positive correlation. Both rose together as developed market central banks slashed interest rates and unleashed wave after wave of monetary stimulus in the form of quantitative easing. Money flooded into everything, including commodities and property. Of course, not all bonds are equal and it is worth noting that many of the most popular high-yield (riskier) bond ETFs fell sharply towards the end of last year. This sell-off foreshadowed the stock market ructions after the New Year.

As the ground shifts, so do the correlations – at least when it comes to short-term market movements. The two most obvious ones are the positive correlation between oil and equities, and the negative correlation between equities and the Japanese yen. The narrative for both is fairly simple and makes sense. As far as crude oil is concerned, beginning some years ago, in their search for yield investors lent large sums of money to companies involved in US shale oil production. This was fine when the oil price was trading around $100 per barrel, but not so good when it fell below $40. Consequently, there are fears that many of the loans made on these ventures will end up going bad. The potential destruction of capital if oil fails to bounce back could prove to be devastating to banks and other investors.

As to the yen, this has been the favourite funding currency for investors for years. This is due to Japan’s hyper-low interest rate which has been pretty much zero since the mid-1990s. On top of this the yen is actively traded and extremely liquid. So when risk appetite is on the increase it makes sense to borrow (sell) yen and invest the proceeds in higher yielding (or growth) assets, such as equities. Obviously, when investors are nervous they sell equities. Then they buy back the borrowed yen to square their books. So, equities fall while the yen rises.

But there are two huge caveats in all this.  Firstly, correlation is not causation, as the economic wonks like saying. A much better expression (and one that predates it by around two thousand years) is “post hoc ergo propter hoc, “or “after this, therefore because of this.” In other words, just because a particular event preceded another one, it doesn’t mean it caused it. Now there are good reasons why a sell-off in crude should be bad for equities. And there is a compelling explanation for why the yen rallies as risk appetite wanes. But the second caveat is perhaps most important: markets can correlate, until they don’t.

Disclaimer:

Spread Co is an execution only service provider. The material on this page is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Spread Co Ltd or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

 

Posted by David Morrison

Category: PM Bulletin


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