A Correlation Is A Correlation Until It Isn’t

``We view financial risk much like popcorn popping in a microwave. Until the first kernel pops, one tends to believe nothing's happening...the initial pop seems like a random event until the second occurs. A third. A fourth. Then the popping goes wild."-Richard Bernstein Merrill Lynch chief investment strategist quoted in Time magazine.

There has not been much change in the markets this week since shakedown began at the end of February. For the moment, we still see a semblance of the same variables that appear to be influential forces at work.

Our Phisix was down 1.21% over the week, as global markets appear to be on a downward trek. Our inspirational leaders the US markets have likewise been down, the Dow Jones Industrials lower 1.35%, S&P 500 1.13% and the Nasdaq .62%.

In the meantime, we saw the Japanese Yen significantly higher up 1.19% while the Swiss Franc likewise higher 2.17%. The significance of these currencies as we have mentioned previously is that they have been presumed to have acted as FUNDING currencies for the so-called CARRY TRADE arbitrage, where the yield spreads against the other currency pairs, have been used as leverage to invest into other asset classes. Such has been said to have provided for the gains in the global cross-asset markets via increased liquidity, which has supported risk taking activities.

The recent turn of events has demonstrably been coincidental with the movements of such currencies giving credence to the belief that the CARRY TRADE could have been a significant factor in the recent upsurge in volatility. Declines in equity and credit markets have been simultaneously seen with the ferocious rally in the Funding currencies.

Yet, this phenomenon called the CARRY TRADE has gone against the traditional economic wisdom called “uncovered interest parity” where to quote the Economist (emphasis mine),

``Countries that offer high interest rates should be compensating investors for the risk that their currency will depreciate. In other words, the forward rate should be a good guess of the likely future spot rate.

``In the real world, uncovered interest parity has not applied over the past 25 years or so. A recent academic study has shown that high-rate currencies have tended to appreciate and low-rate currencies to depreciate, the reverse of theory. Carry-trade strategies would have brought substantial profits, not far short of stockmarket returns, although dealing costs would have limited the size of the bets traders could make.”

In other words, some traditional economic theories as cited above do not seem to apply in today’s rapidly evolving marketplace. Such is the reason why markets may seem so illogical, simply because they act to defy on our beliefs or of past paradigms. Again, the lesson being that past performances does not guarantee future outcomes.

I, for one, while being a skeptic, have observed at this amazing “circumstantial evidence” of correlation, but would not simply write off the possibility or probability of its causal relations with the actions in the financial markets today.

Since the world is undoubtedly extremely leveraged, the carry trade could simply be a part of the growing mechanism to accommodate more leverage.

Nonetheless many analysts, some of whom I highly respect, dismiss on the premises of its correlation based on the lack of direct evidence, in the form of official flows. The Bank of International Settlements (BIS), an international organization of Central Banks, have largely been neutral about this, as evidence have been “mixed” based on global claims as shown in Figure 3.

Figure 3: BIS Tracking the Carry Trade

Claims in Japanese Yen or Swiss Francs have not established any material footprint as with regards to the much touted CARRY TRADE in play. Although the BIS admits that quantifying or measuring the volume of carry trades have been “problematic”, the best evidence they could come up with could be seen via Forex Futures.

According to Patrick McGuire and Christian Upper of BIS, ``Data on open positions in exchange-traded FX futures in potential funding and target currencies provide the strongest evidence for a growth in carry trade activity in recent months. Noncommercial (“speculative”) short positions in yen futures traded in the United States rose between mid-2006 and late February 2007, particularly during periods of yen depreciation (Graph B, righthand panel). By contrast, speculative short positions in the franc yield little evidence of an increase in futures-based carry trades over this period. Data on speculative long positions in FX contracts on the main developed-country target currencies increased considerably in the second half of 2006, but declined somewhat in early 2007 (Graph B, right-hand panel), consistent with the rise and subsequent fall in the carry-to-risk ratio over this period. However, the weekly movements in this ratio appear to explain little of the changes in speculative positions, although the relationship is statistically significant for some currencies”.

As we always say, a correlation is a correlation until it isn’t. While our aim is to distinguish signals from noises, we see correlations as possible clues for signals in determining the future directions, as in the case of the Phisix and the Philippine Peso shown in Figure 4.

Figure 4: Inverse movements of the Phisix and the Peso

The blue arrows above shows of the inflection points of the Peso and coincidentally they have also proven to be counter inflection points for the Phisix, represented by the red arrows. When the Peso declines relative to the US dollar, the Phisix falls vice versa. The correlation seems to have become emergent in 2005.

I have asserted in numerous occasions that portfolio flows at the margins have determined the price variability of the Peso, in contrast to the conventional wisdom that remittances have been its key driver or of other factors suggested by our experts.

If my observations remain valid or cogent, we will see the same patterns unravel as the Phisix corrects or consolidates on the GROUNDS of foreign portfolio outflows on the “reappearance” of global risk aversion.

I believe that markets always convey some latent messages via its price action, so I listen to them and heed their messages instead of trying to “rationalize” or deliver a simplified explanation on their behavior in contrast to our experts or my contemporaries.

My observations of the Peso’s correlation have not been limited to the Phisix but also for Philippine sovereign bonds. In short, circumstantial evidences points to the validity of my theory that the Peso asset classes are set at the margins by portfolio flows.

Figure 5: Asianbondsonline.org: Philippine Sovereign 2 year and 10 year yields

As you can see in Figure 5 courtesy of Asianbondsonline.org, the spike in the Peso over the same rising risk aversion event in May of 2006, simultaneously manifested a jump in the USD relative to the Peso, the decline in the Phisix and equally a jump in yields (falling bond prices) for Philippine sovereign debts.

If I am correct that the countertrend phase is still at work, then the likelihood is that all three markets could show of the same degree of correlation over the interim.

Finally, I still think that today’s market activities are natural cyclical transitions playing out unless proven otherwise. Question is if we are going to see fundamental support for this decline, particularly on the risk of a US recession, this raises the risk of greater degree of volatility.

However, unlike in 2006, today’s shakeout has NOT seen a safe haven rush towards the US dollar. Instead the US dollar, as measured by its Trade weighted Index, continues to swoon even as volatility continues to snowball.

While others argue that emerging markets will drop like a stone if the US goes into a recession, in contrary, I think that the emerging “stagflationary” environment in the US will translate towards further decline in the US dollar and be supportive of the precious metals class and of the emerging markets.

The likelihood is that we will see a departure from presently aligned correlations of ALL market classes with those that thrive under such defined environment.

Following former banker and Citicorp Chairman Walter Wriston’s (1919-2005) principle, ``Money goes where it is wanted and stays where it is well treated”, Asians have treated money well relative to its Anglo-Saxon counterparts and therefore, money flows should be expected to continue.