Shift in the correlation between currencies and stocks

The chart on the left shows the 40-day correlation between the GBP and the FTSE100. For the past two years the correlation has been persistently negative, at times exceeding -50%. With such a correlation a 1% fall in GBP should translate into a 0,5% rise in the FTSE100 index. The economic logic is that a weaker pound means more competitive exports and thus income for large exporters. This correlation, however, shifts to positive in the past few months: in the lower panel you can see the correlation turned positive around June-July this year

This can also be seen in the correlation between EUR and Stoxx50:

Here we can see three episodes of positive correlation, with the current positive correlation being higher than previous episodes.

The combination of a strong dollar and risks to the global economy are most likely suppressing risk appetite for instruments like the euro and European stocks. This can be seen from a simple observation of the chart of EUR/Stoxx50: periods of strong correlation are periods of sell-offs; in other words, positive correlations in these markets means that the markets are in periods of stress and risk-off mood.

This can also be seen from the correlation of USD/JPY and the Nikkei225 index:

We don't think that the present positive levels of correlation can be used for systematic profiting in the markets, because of the risk that the correlation can break apart at any moment and cause serious losses.

It can, however, be used as a barometer of market sentiment. In calm times the currencies of exporters and their respective stock indices should be negatively correlated. The present positive levels indicate a risk-off mood in the markets. We believe that the correlation between the currency and the stock index should be tracked to see if markets are in a calmer or in a more tense mood.

Source: Bloomberg Finance L.P.

Chart: Used with permission of Bloomberg Finance L.P.

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