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I came across a study that confirms just how tightly tied the markets have become. According to James Bianco, president of Bianco Research LLC:
Over the last six months, seven separate assets have maintained an 85%, or better, correlation with the S&P 500.
That means, at least 85% of the time these assets moved the same direction as the S&P 500.
Included in that group of assets is the Reuters/Jefferies CRB Index (a global commodity index), emerging-market bond spreads, and not surprisingly, the euro.
I’ve been consistently discussing the tight correlation between the currencies and stocks.
The reason: As risk ebbs and flows, the buying of U.S. dollars ebbs and flows … in an opposite direction.
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| On Thursday, stocks tumbled to lows not seen since 2002. |
And as witnessed earlier in the week, when the S&P 500 tested new lows and bounced sharply, the U.S. dollar did the opposite — tested new highs and fell back sharply.
Then on Thursday, stocks collapsed again. They tumbled to new lows not seen since 2002, and dragged down the euro right alongside. And once again, the U.S. dollar index broke out to a new high.
These tight correlations are often simply risk ebbing and flowing. But maybe we should look deeper to understand the true driving forces behind recent trends, and ultimately, why these correlations are more dollar-bullish than you might think.
Tight Coupling —
The Values of Bad Assets and
Good Assets Deteriorate Together …
Tight coupling exists throughout the financial markets nearly every single day. A good example would be the recent subprime mortgage fiasco.
Before the entire credit system went ka-boom, the trend was to issue subprime mortgages, bundle them up and sell them to investors.
But then …
- Home prices started falling …
- Borrowers were no longer able to afford loans …
- Bundled loans became less attractive …
- The market for this newly-created product froze up …
- Losses swelled, and …
- Finally, investors isolated from these assets began experiencing losses as the tightly coupled financial industry became unwound and the values of bad assets and good assets began deteriorating together.
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Decoupling Loses Out
To Tight Coupling …
A year ago, the consensus was that the global economy would be fine without the U.S. economy, should the U.S. fall into a nasty recession.
Emerging markets became the story. The growth potential was huge.
The global economy was chugging along …
- The developed world was more than willing to buy China’s cheap stuff …
- China was demanding raw material …
- Small resource-focused economies were thrilled to meet China’s appetite, and …
- The developed world supplied the global capital necessary to keep the party going.
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As it was, emerging economies invested heavily in their export-centric, cheap labor model.
This gravy train was paying off in spades. But then, a wrench got thrown into the mix …
United States Loses the
Ability to Absorb Surpluses …
As emerging markets, including China, invested primarily in their export-centric growth model, they neglected to invest in their domestic sectors. And instead, they took their left-over capital — the capital not already put towards building exports — and shoveled it into the U.S. in exchange for safe investment returns.
The problem arose when the U.S. financial markets could no longer find places to channel this flood of money.
All sorts of new-fangled investment products were created, including derivatives, in hopes of allowing liquidity to flow efficiently. But of course, as is the case with tight coupling, the complexity of the new initiatives opened the door for disaster.
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Asset bubbles inflated and popped. And investors realized they had little understanding of the new financial instruments.
And now …
- Consumers are watching their stocks and housing wealth evaporate …
- Spending across developed nations is retreating, and …
- Export-centric growth models are suffering as global liquidity vanishes.
This is a process that cannot be stopped effectively. Naturally the cycle will find its end. And unnaturally “officials of last-resort” will try to come in and stem the unraveling. But that just makes things more complex and increases the likelihood of unintended consequences.
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| Risk-aversion supports the beginnings of a long-term dollar bull market. |
It is for all these reasons that so many markets — dependent upon the continued flow of liquidity — have become so extremely correlated now that global capital flow has morphed. What this has done is create a trend primarily away from risk-taking and towards risk-aversion.
I’m of the opinion that the United States maintains the world’s largest capacity to produce wealth. And risk-aversion will continue to steer capital back to the U.S.
This supports the beginnings of a long-term dollar bull market in the making.
Best wishes,
Jack
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