Top Story

Why the Vix is losing its impact as market correlations break down

We’ve noticed some strange market reactions this week, on the one hand stocks are looking very shaky as some key support levels are tested and the Vix index is at its highest level for 6-months. However, on the other hand, emerging market currencies are holding up well vs. the USD, the South African rand is one of the top performers vs. the USD this week, and the US corporate high yield debt spread with Treasury yields remains remarkably stable at 3.5%. So what is going on?

Why correlations matter

Correlations between risky assets have been breaking down since the start of April, which is significant. In times of market crisis we tend to see risky assets act as one block and rise and fall in unison. The fact that this is not happening suggests a couple of things: firstly, we are not in a period of market panic, and secondly, that any sell-off in some risky assets such as US stocks could be mild and may not signal contagion to other asset classes.

Below are two correlation matrices that compare correlations between the S&P 500, USDJPY, the US high yield credit spread with Treasuries and USDZAR. Figure 1 shows the correlations from the start of the year, and figure 2 shows the correlations since the start of April.

Figure 1:

Source: City Index and Bloomberg

Figure 2:

Source: City Index and Bloomberg

Here are some conclusions:

• Overall, we are seeing the largest breakdown in correlations between the S&P 500 and the other products included in the matrix.

• This suggests that movements in the S&P 500 are having less of an impact on other asset prices.

• At the start of 2017 the correlation between the S&P 500 and the high yield corporate spread was -53%. This seems normal as you would expect these products to move inversely to each other: as the S&P 500 rises, high yield debt falls and vice versa. However at the start of April this correlation had reversed to 33%, so now the S&P 500 and the high yield debt spread move together a third of the time. This suggests that 33% of the time when the S&P 500 falls, so too does the price of credit for high risk US corporations. Usually you would expect the opposite to occur.

• The correlation between the S&P 500 and USDJPY has also fallen from 32% in January to 26% this month. Both of these products are sensitive to risk sentiment, yet so far this month they have mostly moved independently of each other.

• In contrast USD/JPY and the high yield credit spread have become more sensitive to each other, with the correlation rising to -67% in April, from -51% in January.

• USDZAR has maintained an insignificant correlation with USD/JPY and the high yield US credit spread, so far this year, and does not seem to have significant correlations with any other risky asset class, suggesting that is being driven by domestic drivers.

• Overall, don’t use the S&P 500 or USD/ZAR as a gauge of risk sentiment. More significant is the relationship between the US high yield corporate spread with Treasuries and USD/JPY.

Is the Vix becoming an unreliable market indicator?

The breakdown in the correlations between the S&P 500 and other asset classes has ramifications for reliability of the Vix, which measures volatility based on options on the S&P 500. If the S&P 500 is less correlated to risky assets then a spike in the Vix may not be a good gauge of fear on Wall Street, and just because the S&P 500 takes a dip does not mean that contagion will spread to other asset classes.

Disclaimer: The information on this web site is not targeted at the general public of any particular country. It is not intended for distribution to residents in any country where such distribution or use would contravene any local law or regulatory requirement. The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warranty that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.

Futures, Options on Futures, Foreign Exchange and other leveraged products involves significant risk of loss and is not suitable for all investors. Losses can exceed your deposits. Increasing leverage increases risk. Spot Gold and Silver contracts are not subject to regulation under the U.S. Commodity Exchange Act. Contracts for Difference (CFDs) are not available for US residents. Before deciding to trade forex and commodity futures, you should carefully consider your financial objectives, level of experience and risk appetite. Any opinions, news, research, analyses, prices or other information contained herein is intended as general information about the subject matter covered and is provided with the understanding that we do not provide any investment, legal, or tax advice. You should consult with appropriate counsel or other advisors on all investment, legal, or tax matters. References to or GAIN Capital refer to GAIN Capital Holdings Inc. and its subsidiaries. Please read Characteristics and Risks of Standardized Options.

The markets are moving. Stop missing out.