Euro Movers: Correlations Reviewed

There has been much talk in recent weeks that risk-on/risk-off trades, in which many instruments seemed to be highly correlated, may be breaking down. We have taken a fresh look at our correlation matrix. At a proxy we look at the correlations with the euro. We run our correlations on percentage change as we believe it is a more robust approach.

We find that there has been no breakdown in the correlation of the euro and the S&P 500. In fact, it has tighten in the recent period. Consider that for all of 2009, the correlation was about 50%. Over the past three months, it has risen to 59% and in the past month, it stands at almost 63%.

We looked not only at the overall US stock market, but also at US bank shares, using the XLF ETF (Financial Select Sector) and a similar tightening of the correlations. For 2009 as a whole, the euro and XLF were 40% correlated. Over the past three months, the correlation increased to 43% and over the past month it stands at 52.5%, which is more than the S&P/Euro correlation for all of last year.

Next we look at the euro's correlation with gold. In 2009, the euro and the precious yellow metal were correlated 31%. Over the past three months the correlation increased to almost 72% and over the past month it is nearly 83%. This seems to underscore our suspicion that rather than a safe haven and an refuge from the debasement of paper assets, the gold is part of the risk-on trade.

One area that the euro correlations have softened is with commodities in general, like the CRB index and oil. The correlations over the past month are less than over the past three months, but higher than 2009 as a whole.

This may raise questions over potential new movers for the euro. We note that the euro's inverse correlation with US Treasuries is increasing. For all of last year, the inverse correlations are weak, but they have increased in recent months. This is particularly true of the US 2-year note. For all of last year, there was a slight positive correlation, but over the past three months it switched to negative (-11.7%), but over the past month it stands at -43%. The correlation with the 10-year note and 30-year bond have also switched signs to negative and are tightening, but from low bases. Over the past three months the 10-year US Treasury and the euro are inversely correlated by 7% and over the past month, the correlation is -16%. Turning to the 30-year bond, the inverse correlation with the euro stood at -12% over the past 3 months and doubled to -26% over the past month.

This is largely consistent with our view that over time, US rates will rise relative to many other countries, including the euro zone and that this will undermine some of the financial incentives that has made the dollar a favored funding currency and that this will see the risk-on/risk-off theme disintegrate and that the dollar will find better traction. It seems largely a question of timing and but we suspect that December 2009 and January 2010 is too early.