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Stock and FX Correlations Confirm the Rally

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In "Two Themes To Watch for 2013", I said that continued improvement in economic fundamentals would bring an end to two of the unusual market dynamics that have been features of the last several years. First, we should expect to see declining realized correlations among stocks and other major asset classes. Second, the return of the carry trade. The idea uniting these two changes is that investment flows will depend less on global risks and more on local events. People will buy stocks less because of what central banks might do, and more because of the fundamentals of the underlying business; managers focused on currencies will be motivated less by the flight-to-safety and "risk on/risk off" trades of recent years and more by the fundamentals of local economies.
SPX 2013/2013 Implied Correlation Indexes
Source: CBOE

Both of those changes are already happening. Realized stock correlation has plummeted, and option-implied correlation S&P 500 correlation estimates are lower, too. The index for 2013 expiration closed near its absolute lows, and the 2014 index is also seeing steady downward momentum. (fig. 1)

And in a recent note, John Normand from J.P. Morgan explains that thawing currency market correlations and leading FX managers to some of their best performance in years. The three-month realized correlation of global currencies to the USD has reached levels not seen since the collapse of Lehman:

"For fund managers who bemoaned the risk-on/risk-off (RORO) tyranny of the past three years, in which diversification was unattainable since global markets and USD pairs rose or fell uniformly in response to global events, 2013 should be refreshing. The ongoing slide in USD-based correlations reflects as much the fading of systemic risks (US fiscal cliff) as it does the rise of local ones. Currency markets haven't seen this much diversification in five years, which may explain why currency managers are up about 2% in January alone (chart 1), equal to their average annual gain over the past decade." (h/t FT Alphaville)

All of this is good news for investors and policymakers. When you factor in strong U.S. economic data, the total lack of complacency in the VIX, and these improvements in stock and FX correlations, the year ahead looks promising. The familiar risk scenarios will probably always be with us, but the metrics that really matter are all pointing in the same direction.

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