Join Date Jan 2007 Posts 16,888

Is The Correlation Between Carry Trades And Equities Fading?

Ever since the subprime credit crisis struck the financial markets last summer, carry traders have been struggling. The glory days of high yield and consistent capital appreciation are behind us, leaving many traders desperate for answers on when carry trades will resume their rally for good. One of the correlations that have become water cooler talk in the FX world is the relationship between Currencies and Equities, or more specifically the Dow and Carry trades. Over the past few years, we have often seen these two underlying assets rise in tandem. However with global equities, bonds, commodities and other risky assets seeing extreme volatility, this relationship is breaking. So, is this a temporary divergence or is the correlation destined to breakdown for good?

Stocks Moving In Lock Step With The Carry Trade

The following chart shows a close connection between the carry trade and the more popular risky assets like equities. While the extent of rallies and declines may have diverged for brief periods, the two have more or less headed in the same direction with incredible accuracy. This tight correlation is a product of a few factors. The first tie between the two comes from the globalization of financial markets and investment. With many traditional brokers and discount trading firms opening access to cross border investments, currency exposure is now a well used phrase in most traders lexicon. Therefore, when investors are looking to take on more risk, they will invest not only in domestic markets, but also those markets that are presumed to offer higher yields. When this occurs, capital is flowing into risky, traditional assets like equities and at the same time lifting those currency pairs with a hefty yield differential. And, just as one would think, with investors seeking the greatest return on their money, money will flow to the economies with the highest yield: and, in doing so, accelerate the rally in the carry trade in proportion to the pairs yield. On the other end of the spectrum, the carry trade has also been deemed a trade in itself. With the rise of retail forex, speculators have entered the currency market and have quickly begun to exploit the tried and true strategies. Within the play book, the carry trade was immediately a popular strategy as the daily roll offered a more consistent income than traditional dividends. Whats more, the optimal conditions of steadily rising risk appetite and low volatility (the exact market setting between 2002 and 2007) that would lead to a steady rise in the equity markets would also be the best environment for collecting the steady yield in the carry trade.

Is The Correlation Fading?

Those traders who jumped on the carry trade/equity market correlation back when the subprime meltdown triggered a surge in volatility last July have enjoyed a particularly profitable period for trading this strategy. The connection between the two tightened through the period thanks to panic unwinding of all things deemed risky. As many traders have seen, nothing unites the markets more than fear-based selling. However, these same conditions may also break the correlation down; and there have been signs of just that recently. Looking at the graph below, February has seen a large swing in the Dow Jones Industrial Average (the blue line) that a relatively stable USDJPY (the maroon line) has not participated in. Does this mean the correlation will break down forever, or is this a period of divergence that will soon pass? To answer this question, we need to understand why the relationship has deteriorated recently. Perhaps the most immediate reason for the breakdown comes from the same dynamic that tightened the correlation over the past two quarters. Besides triggering a wave of risk reversion, the subprime blow up in the US has ushered in a turn in global expansion and interest rates. Monetary policy across the industrialized world has tangibly turned increasingly dovish, and nowhere is that more apparent than with the Federal Reserve in the US. Naturally, a lower benchmark lending rate is a bullish driver for stocks as cheap lending encourages consumer spending and business investment. For the carry, on the other hand, lower lending rates equates to lower return. For USDJPY the premier, liquid carry trade the Feds cumulative 225 basis points of monetary easing and the Bank of Japans unchanged overnight rate have cut the pairs carry from 4.75 percent to 2.50 percent. And, with the Fed expected to continue its efforts to ease monetary policy and the Japanese central bank seeing little room to lower its own, the differential looks to only diminish with time.

The reduced yield income potential highlights another weakening effect for the carry trade/equity market correlation. As mentioned above, investment in the carry trade strengthens during periods of low volatility. Essentially, when FX traders look to take advantage of the yield differentials, they measure whether the return from the carry compensates the risk taken. For this strategy, the risk from holding a currency pair to collect the daily roll comes from the potential for capital losses which rises dramatically when volatility jumps. For the USDJPY traders, a 20 percent annual return on ten-to-one leverage doesnt look so appealing when a dive in the USDJPY force a margin call in a matter of weeks or days. At the same time, volatility doesnt carry the same negative bearing for stocks. A general increase in price action may mean larger daily ranges, though it doesnt necessarily lead investors to exit the market and push stocks lower. In fact, higher volatility usually attracts more investors to equities.

Finally, the markets may be shifting their focus from yield to growth. With the Federal Reserve cutting interest rates aggressively, many people believe that there will be a shallow downturn and swift recovery. This would be beneficial for the stock market and may be the reason why the dollar has been rallying, pushing carry trades like AUD/USD and EUR/USD lower. The fear is that these countries who have yet to lower interest rates like Australia and the Eurozone will find themselves behind the curve struggling with slowing growth at a time when the US economy has hit a bottom.

In which way do you think the markets are shifting their focus? Discuss your opinion or see what others think at the DailyFX Forum .

Will The Correlation Resume?

There are many economic factors working against the steadfast carry trade/equity market correlation and we are seeing evidence that the relationship is struggling. However, does this mean this interesting inter-market connection will fail for good? In one word: no. The turn in global expansion and interest rates clearly has an opposing effect on the two markets, but the divergence will only last as long as growth cools. When the global economy stabilizes and stocks stop falling, equity investors will be will plow into the market, signaling the beginning of a bullish wave. When monetary policy starts to catch up to the improving economy, carry traders will once again see the optimal conditions for their favored strategy. From this, it is clear that the correlation between the carry trade and equity markets will likely always exist, it will just go through periods where it is tight and when it fades. Those that anticipate return of the correlation will be in a position to take advantage of the strategy while others are still trying to pick a direction on the stock market or USDJPY.

To see the general direction of where markets may be heading check out our Speculative Sentiment Index.

Written By John Kicklighter. Currency Analyst for DailyFX.com

Have comments or questions on this or other articles authored by John? E-mail him at jkicklighter@dailyfx.com .