Correlations 2014: It's All About the USD
2013 was the year when the risk on/off rhetoric disappeared from our radar. As can be seen below, the concentration index fell back to "normal" levels (read: pre-Great recession levels) meaning that asset price returns are now driven by a larger set of explanatory variables (for example commodities were more driven by their supply outlook, some FX pairs by their CB's monetary policies not just VIX).
A less expected event was the announcement of the tapering. It might not have been implemented for reasons linked to growth and the government shutdown but it dealt a blow on many correlations, as the chart below shows (the correlations here are based on weekly returns, not levels - the direct calculation on absolute prices tends to overestimate the relationship):
1. The S&P 500 return used to be positively correlated with the economic news flow but the relationship inverted in late summer. This feature is confirmed by the chart below which shows that the S&P 500 3-month return has diverged from the changes in the ISM composite PMI. This is a great concern for those like me who have advocated the resilience of the relationship between stock returns and short run economic cycle. If stocks tracked PMIs, the S&P 500 should be around 10% higher. The distance could be explained by Treasury yields as shown below.
2. The long lasting negative correlation between the USD and the S&P 500 also took a hit this year. Interestingly enough, the correlation breakdown was initiated earlier in 2013 as investors expected the Fed to tighten one way or another. Yet, the current reading may show that the dollar is no longer negatively correlated to US stock prices but the reverse is not true: the correlation currently stands within an insignificant range.
3. Oil prices (Brent) slowly disconnected from stock price actions for most of 2013 as a combination of growing supply and OPEC management of prices around their target of 110/100 USD/b..
To understand better the game changer of 2013, we need to look at the following chart that highlights to what extent US 10-year Treasuries have been and will probably continue to be the main drivers of risky assets next year.
1. Clearly the USD seems to have entered into a new regime: a robust and positive correlation with US Treasury yields. The chart below suggests that it simply looks like a return to normal. Even though the date of the first rate hike is well ahead of us, the tapering (early 2014) will definitely change the course of US long term yields.
2. More puzzling is the reversal in the Stock/bond correlation. Higher rates could of course mean lower stock returns as discounted future earnings would be lowered. But higher yields are a signal that growth remains robust, which should be supportive for US stocks - especially since, as can be seen below, most of the adjustment will come through higher real yields.
Bottom line: The reversal of the correlation between the USD and US treasury 10-year yield should be the key driver of asset prices in 2014.
In all likelihood the USD will strengthen as yields are expected on the upside (3.5% at year-end is likely). The impact on US stocks is not straightforward yet. I would stress that even though the correlation between USD changes and stock returns is now positive, it is barely significant. It hard then to bet on a stronger dollar to play higher returns for stocks.
More annoying is the negative correlation between the USD and US Treasury yields. A look at the chart below shows that in the past, episodes of correlation breakdowns barely last. In addition, they occurred when the uncertainty on the future path of monetary policy was high -which is clearly the case today.
Even though the uncertainty on the future path of monetary policy may last longer than in past episodes of monetary policy tightening (overlapping tapering and forward guidance), history would suggest that a long lasting period of negative correlation between stocks returns and US Treasury yields can be ruled out.
For that reason I am seriously considering about being long US stocks (NYSEARCA:SPY) -with a lower exposure than last year: valuations may not be over-stretched they are on the upper bound of fair pricing, long USD and short US Treasuries (NYSEARCA:TLO).