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Financial markets and the economy

Risk on/risk off
Nov 11th 2010, 14:10 by Buttonwood

DAVID Bloom, the currency strategist at HSBC, has just unveiled a fascinating analysis of the links between different asset markets. (Sadly no link because it is a privately-published research note.) He writes about the tendency in recent years for the markets to be either risk on (equities, high-yield bonds, Aussie dollar up) or risk off (bonds up, dollar up). At times, this had made life very difficult for hedge fund managers to add value since there has been little differentiation within asset classes; stocks have risen or fallen in tandem. And it makes it difficult for normal investors to diversify their portfolios. The tendency for correlations between asset classes to go to 1 in a crisis is well known. That happened in the Asian crisis of 1997-98 and during the credit crunch, although not during the bursting of the dotcom bubble. But Bloom has constructed a correlation index (RORO for risk on/risk off) to show how correlations have grown over time. The trend has been steadily upwards since 1990 and the RORO index is now at its highest level yet, even although the worst of the panic is over. Volatility has fallen from the 2008 high, but correlations have not. Why is this? One possibility is that the outcome is truly uncertain between robust recovery (favouring equities), stagnation (bonds) and high inflation (gold). Another possibility is the globalisation of markets, with local factors now replaced by macro themes driven by the big investment banks and hedge funds. The least correlated assets with the RORO trade are gold (which has been rising, come what may) and the British pound (answers on a postcard, please). The highest correlated assets are, not surprisingly, the big equity indices (S&P 500). We have come out of a long "risk on" period and the markets seem to be deciding how serious the European fiscal situation is, before switching to risk-off. it may be significant that the euro/dollar rate has been trending down in recent days.