Cross-Asset Correlation Heatmap as of end of June 2013

I have just gotten round to churning out the next batch of correlation heatmaps, since I was very occupied over the course of the academic year, especially in the Winter Semester. Anyway, here are the high resolution heatmaps, and I will conclude this post with some of my observations.

m011012to281212 labelled

m311212to290313 labelled

m010413to280613 labelled

The increased correlation of treasuries and equities is stark, especially in Q2 2013. The developments and reasons for this is baffling (to me at least).

First, FOMC minutes released suggests that in spite of “taper talks”, slamming down the break is far from being concrete. In fact, as the FT reports, the minutes send largely mixed signals. While unemployment rate and the 2% inflation target are part of the key conditions that guides policy decisions, Fed officials also warned that they could intervene if market reaction jeapordises the achievement of these goals.

Second, the increased correlation of treasuries and equities is confusing for me. On one hand, the fact that CBs are confident enough to withdraw the QE programmes would suggest that the economy is recovering, that should be good news. But then, stock markets reacted to that by moving down, thus causing the fall in both Treasuries and Equities, a development that wasn’t confined to the USA.

On further note, it is expected that bond prices will tumble, and this is a view that is emphasised by a fancy passive investment firm who presented in one of the classes I took over the Winter. In their view, bonds are over-priced. But an increase in risk-free rates will make the expected returns of equities fall(for stocks with Beta greater than 1), making them more expensive, but would perhaps reduce volatility, which is good for risk-averse investors.

So what to look out for? Here’s my list:
1) Labour Market Conditions – I hardly hear discussions on “tightness” of the labour market, with the views emphasised in labour economics. Have we looked at the vacancy yield? (Vacancy/unemployment rate). When this improves, one of the QE tapering conditions would have been fulfilled.

2) Composition of the Treasury Yield. Pay attention to the short term interest rates (intersection of IS-LM for you Keynesians), expected inflation (proxy with “Breakeven Inflation” by subtracting yield of Treasuries with Inflation Protected Treasuries of same maturity) and the interest “term-premium.” Withdrawal of Fed support should drive up the term premium that were kept low, and a recovery would also imply higher return on capital (IS-LM) intersection.

3) What is the outlook of the economic environment? The IMF just slashed world GDP growth forecast; China’s GDP growth seems likely to contract what with the clamp down on banking liquidity, export-import data gleaned so far in China suggests a slowdown; the Euro Area seems to be segmented by core and peripheral markets, with heavy focus on Portugal recently and  talks on risks of bond “restructuring.” Don’t think ECB will follow the Fed too much, since the Euro Area are faces its own unique problem, and the PIIGS issues would not be too dependent on development in the US economy. Overall, the heuristic here is bad economic environment are bad news for equities. So withdrawal of Fed support, ceteris paribus, would make equities more expensive.If earnings outlook is bleak, then it follows the equities will take a tumble.

Edited on 20th July 2013 to make heatmaps “clickable.”
On 29th July to clarify a misleading and ambiguous sentence. 



Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: