Market Correlations Wax and Wane Offering Critical Insight and Plenty of Traps

The saying ‘correlation is not necessarily causation’ speaks to a strong pull – but also common fallacy – in the markets happenstance alignment is mistaken as a common driver. Correlations are critical for hedging, identifying systemic influences and tracking fundamental narratives; so how do we avoid being led astray?

Talking Points:

• Correlations can be very insightful for traders and investors, but they also change over time while some relationships are only happenstance 
• Relationships born of a common origin can be influenced by exogenous forces like Japan’s intervention or wane in importance in the face of greater priority fundamentals
• We discuss correlations around stock and bonds, USDJPY and yields as well as evolutions of fundamental relationships for Bitcoin and the US Dollar

 

To sign up for the Trading Global Macro podcast, find it on your preferred podcast platform: Apple Podcasts, Spotify, or YouTube.

 

‘Correlation is not causation’ is a common enough saying. More appropriately as it pertains to markets, the statement is accurately summarized as ‘correlation does not necessarily imply causation and relationships change over time’. Correlation speaks to a level of alignment between two or more markets. This can purely by chance, it can reflect a situation where a common motivator is aligning the markets or that one market’s movement is influencing the other. Knowing the circumstances between a perceived relationship we find in the markets is important to interpreting the signal it offers…if there is indeed an insight to be gleaned.

We Tend to See Correlations Everywhere

Along with humans innate intelligence as a specifies, there is a strong pattern recognition engrained within our biological adaptation. For our ancestors, if there is a plant, water source or locale that has proven dangerous; they would recognize the catalyst and adapt their habits to avoid the threat. Those more serious natural skills have carried forward to more prosaic endeavors such as evaluating charts for the most advantageous investment of funds.

Arguably one of the most misleading market influences to unravelling success in the markets is to evaluate and pursue all perceived relationships at face value. Simply considering the probability of recognizing a meaningful correlation versus a coincidental pattern, we are dealing with a skew right from the jump. Popular, spurious market drivers include evaluating speculative appetites against lunar cycles or even US NFL Super Bowl wins by NFC vs AFC teams alignment to stock market performance. There may be some degree of alignment – or more belief than evidence – but it doesn’t have a basis in actual fundamentals. 

Chart of S&P 500 with Lunar Cycle (Daily)

Source: TradingView.com; John Kicklighter

 

Practical Hedging and Investing: The 60/40 Rule

In contrast to the improbable, there are established relationships between markets that form the basis of long-standing investment theory. Arguably the most familiar correlation is established between stocks and bonds, formulating the ‘balanced portfolio’ that optimizes return over time. There are different assets and percentages that are combined according to different theorems and observers, but the 60/40 rule is arguably one of the most common.

According to the textbook theory, a split of 60 percent exposure to stocks and 40 percent fixed incomes (bonds) can yield superior results over time. There are plenty of reasons – and periods through time – to flag that as a dubious mix; but the popularity persists. In general, that market sentiment exists on a spectrum where the collective is either seeking safety or higher return creates a reasonable assumption as to how funds are likely to be allocated in evolving conditions. Over a longer period of time, this negative correlation can help normalize returns – capping gains of one leg but also helping offset some loss from downturns.

Chart of S&P 500 and TLT ETF with 20-Day Correlation

Source: TradingView.com; John Kicklighter

 

When Correlations Built on Causation Experience Interference: USDJPY

Looking across the market, there are certain correlations that speak to a foundational causation which external influences can actively work to break up. A great current example of this effort at affecting a steer comes on the behalf of the USDJPY exchange rate. One of the most liquid currency pairs in the world, there are certain shared qualities between the US dollar and Japanese yen – including the reality that both are very liquid, backed by exceptionally large economies with qualities of a harbor to global capital in tumultuous seas.

That said, between the two currencies, the US dollar and its backing sovereign debt market are far and away the market’s benchmark when fear boils over. At extremes of risk aversion, the Greenback will draw disproportionately more capital seeking shelter. Then again, in ‘good times’, the US dollar historically holds a meaningful yield advantage against the perpetually lower benchmark for Japan, creating a long-standing carry trade bearing. In more extreme risk on or risk off conditions, the alignment to – or unwind of – carry trade can cater to the USDJPY and its yield spread. Then again, in middling periods, the correlation can wane. 

Chart of USDJPY Exchange Rate and US-Japan 2-Year Yield Spread (Daily)

Source: TradingView.com; John Kicklighter

 

Correlations Can and Do Change…Which Offer Insights: USD

Correlations – like anything else in the market – can and do change. In fact, when we can monitor those changes over time, it can offer us more valuable insights into the broader market than a simple statement on a single (or two) markets that we are observing. A good example of this signaling factor can be found in the relationship of the US dollar to various drivers. The benchmark currency plays a number of different roles that change prominence according to what market influence is most prevalent. 

As the most liquid currency backing the largest economy in the world, the dollar sits at the nexus of a number of critical themes. It is an ultimate safe haven in the search of absolute liquidity in severe risk aversion. It is the representative of fiat currency – more often when the world is seeking alternative to debt-backed fiscal authorities. There is carry consideration for a typically higher-yielding benchmark when conditions/inflation improves. There is also a global appeal to large local capital markets (eg S&P 500) that serves in passive ‘risk on’ scenarios. How the dollar aligns to different benchmarks versus others, can tell us which of these themes is more important than others. That can aid in analysis of broader markets than just a view on the Greenback. 

US DXY Dollar Index and VIX Volatility Index Correlation (Daily)

Source: TradingView.com; John Kicklighter

 

Misleading Claims of Correlation and Causation: Bitcoin

Sometimes, narratives can promote correlations as reflections of certain causation that strains credulity when we consider the actual fundamentals or market factors beyond the supposed relationship. A very popular, recent example of this is arguably found in larger trends of the crypto market’s most popular member: Bitcoin. The defi space and this symbolic benchmark were billed early on as a new alternative to fiat that would unshackle peoples’ income and wealth from the prying eyes and taxes of governments. In the meantime, it was sold as a store of wealth on par with the most liquid traditional currencies. This can be a very appealing scenario for many, but is it practical consider governments who back fiat and rely on them to fund debt and raise taxes will simply allow a convenient work around? 

Setting aside the alluring – and lurid – fundamental prospects of Bitcoin, there is unquestionable value to be found in crypto that can play a critical role in the plumbing of the financial system. The ability to speed up and make more accurate custody and clearing in traditional markets is no small value-add. And yet, it isn’t as compelling as headlines that ‘the Greenback’s replacement is at hand’. Nevertheless, there is an adoption face to new markets with considerable promise – be it as replacement fiat or expansive protection node in global markets – which appeals to opportunistic funds. That is perhaps why BTCUSD has a better correlation to the S&P 500 than it does inverse correlation to the Greenback. 

BTCUSD Overlaid with S&P 500 and Inverted DXY Dollar Index (Daily)

Source: TradingView.com; John Kicklighter

 

Access More Global Macro Insights, Forecasts and Tools

 

Stay connected to timely global macro analysis designed to help market participants navigate shifting economic conditions and evolving risk. Gain access to regular market commentary, updated quarterly forecasts, a comprehensive two-week forward economic event calendar, and specialized tools built to support informed trading and risk management decisions.

Sign Up Here

 

-- Experts: John Kicklighter, Global Head of Content; Matt Weller, Global Head of Market Research