Article / 26 August 2015 at 10:30 GMT

Weekly Bond Update: Correlation breakdown is key

Head of Fixed Income / Saxo Bank
Denmark
  • China fears and US hike worries don't fully explain rout
  • The breakdown of correlation is the key
  • New models can imply nasty surprises
  • The good news is there will be buying opportunities

By Simon Fasdal

The selloff that we just saw in equity markets was brutal and short but most importantly, lacked a single compelling explanation as to why all major markets took such a steep dive. Well, fear of lower growth in China and worries of a possible US rate hike in September (which still looks low probability to me) have been cited as key factors. However, this explanation is insufficient. The extent of the intraday volatility and the sheer violence of market moves makes it clear that something else was going on.

For one thing, there was no rush into buying in core bonds. This is the classic knee-jerk reaction to equity market panic but it didn't happen this time. This lack of negative correlation between stocks and bonds was also seen in other asset classes – commodities, gold, emerging markets, bonds and equities. Everything is moving the same way...down. 

The ability to exploit negative or non correlation between asset classes is classic portfolio approach, so nothing new, and in the long run these basic rules probably still hold water.
 
But with the invention of 2nd generation portfolio models, like the "risk parity" model and other similar strategies, asset managers are leveraging, magnifying and squeezing the benefits of correlation patterns between asset classes, resulting in high returns in environments (low yield) where nice returns normally are absent. They are making lemonade on the lemon peel.

lemon
High returns in low-yield environments is like making lemonade on the peel only. 
It might look like a result but things could quickly turn sour. Photo: iStock

At some point these model will enter environments where their "all weather" ability is offset. especially in leveraged models where you depend on the correlation between the four major asset classes – equities, interest rates, commodities and credit. If risk (and loss) gets too high, the model has a cure: risk is simply scaled down by selling off assets to match the risk target in the model. And as we saw on Monday, there are more than a few of these models around, sufficient, together with other factors, to provoke an all-out selloff in nearly all major market and asset classes on the globe.

This is a theme that will have focus in the market, and probably bring volatility into it as well. The good news is there will be buying opportunities on the way, and at some point old correlation patterns will eventually return, though they may be dislocated for quite a while yet.

Click here for interview with Simon on Saxo TV
 
— Edited by Clare MacCarthy

Simon Fasdal is head of fixed income trading at Saxo Bank
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Corporate Bind Update, week 35 - 2015

2y
Alex Forrest Whiting Alex Forrest Whiting
Great explanation Simon
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