Changing correlation indicates systemic risk
By Evaldo Albuquerque
As a trader, I always like to look at correlation between different asset classes. Correlation analysis can be very helpful in indentifying possible new trends. If you’re bullish on oil, for example, you can buy the Canadian dollar or the Mexican peso, since those two currencies tend to follow the price of oil.
Other times correlation can indicate change in market dynamics, especially when there’s a sudden change of correlation. The correlation between the euro and the stock market, for example, has been changing lately.
Up until April, there was a slight negative correlation between the euro and the S&P500, with equities moving higher, while euro moving lower. That indicated the market’s view that the problems in Europe would not affect global growth. But in May that correlation changed.
As you can see in the chart, during that month both the S&P500 and the euro moved down, indicating a change in market sentiment. The positive correlation seen in May indicates the risk that the euro crisis may actually slow down global recovery.
Recently we’re seeing the stock market moving higher, while the euro continues to fall. It’s too early to tell if this is another change in correlation. If it is, that would indicate the euro is once again being used as a funding currency and that the market expects European risks to stay limited to Europe.