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Traders vulnerable as market volatility breaks familiar correlations
[LONDON] The high degree of market volatility this year has unnerved investors not only because of the losses it has triggered but also because of the damage it has done to familiar trading patterns and strategies across asset classes.
Central to the breakdown in many correlations are the Japanese yen and oil. Both feature in a wide range of investors'portfolios, are among the world's most liquid assets, and are viewed as barometers of risk appetite.
Broadly speaking, a rising oil price is inflationary, reflects a more optimistic economic outlook, and a willingness on the part of investors to take on risk. A strengthening yen, on the other hand, generally signifies the opposite.
Both have been on wild rides this year, catching many investors off guard with the direction or ferocity of their moves.
Having plunged below US$30 a barrel in January from US$115 in mid-2014, Brent crude has since soared 60 per cent. The yen, to the surprise of many who might have expected it to fall, has surged 10 per cent against the dollar since the Bank of Japan stunned markets by introducing negative interest rates in January.
These are seismic shifts in the price of two of the world's most liquid and important financial assets and have wreaked havoc on investors' portfolios and trading models.
And coming in the first quarter, usually the most lucrative period for banks as investors put money to work, the impact has been devastating.
"This is a very difficult period for the market with oil prices rising and risk sentiment healing, but inflation expectations and bond yields not responding," said Kenneth Broux, head of corporate research, FX and rates at Societe Generale.
"We had the big fall in dollar/yen because investors were selling into bounces all the time regardless of what was happening in stocks, no matter what the BOJ was saying or doing," he said.
First-quarter earnings from US banks confirm the three months to March was an extremely challenging period for markets. Revenue from market trading at JPMorgan fell 13 per cent and 17 per cent at Bank of America, leading to overall declines in profits.
Several banks, notably Credit Suisse, have recently announced large-scale job cuts and more are likely to follow the Q1 earnings season.
Hedge funds had a torrid time in early 2016 but recovered in recent weeks thanks to the rebound in world stocks and emerging markets.
Hedge funds were down 0.52 per cent at the end of Q1, according to industry tracker Eurekahedge, but some big-name funds had their worst start to a year on record.
A perfect positive correlation of +1 implies that as one asset moves, in either direction, another moves in tandem in the same direction. A perfect negative correlation of -1 is when one asset moves in one direction and another moves in tandem but in the opposite direction.
With the exception of December, the correlation of dollar/yen with Brent over the past year has been negative, going as low as -0.65 in January. But on Thursday it rose to a three-month high of -0.04, within a whisker of turning positive.
Dollar/yen often follows a similar pattern to the spread between US and Japanese 10-year bond yields. A widening spread signifies a more attractive premium for buying Treasuries over Japanese bonds, drawing in Japanese investors and lifting dollar/yen.
But this relationship broke down in late February. The yield spread rose to 205 basis points in mid-March, its widest in 17 months, while the dollar fell to a 17-month low of 107.60 yen earlier this month.
Curiously, two of the world's best-performing currencies this year are at the opposite ends of the risk scale. One is the safe-haven yen, the other is the Brazilian real.
Brazil's economy is in a deep recession but the real has rallied 14 per cent this year as investors have bet that embattled President Dilma Rousseff will be impeached and that her exit will help pave the way to recovery.
A mixture of safe-haven buying and repatriation flows from Japanese investors has boosted the yen 10 per cent.
"It's not often you have best performing currencies the yen and real - they're very odd bedfellows, and it shows how volatile risk appetite has been and how classic correlations are breaking down," Tim Graf, managing director and head of macro strategy, EMEA, at State Street in London.