LONDON, March 6 (IFR) - High levels of correlation that have characterised financial markets since the global financial crisis have broken down in recent months, according to the Bank for International Settlements.
Returns between asset classes, regions and sectors have diverged, the BIS notes in its latest report released today on the three months to end-December. Political uncertainty and divergent monetary policy have replaced the large swings in investor risk appetite that acted as a driver of overall valuations in recent years.
“Politics tightened its grip over financial markets in the past quarter, reasserting its supremacy over economics,” said Claudio Borio, head of the monetary and economic department at the BIS.
Cross-asset correlations have been on the decline since late 2015, according to the BIS, but plummeted following November’s US presidential election.
“The breakdown in correlations stands in stark contrast to most of the post-crisis experience, when successive waves of risk-on/risk-off behaviour tended to raise and lower all boats,” said Borio.
“This break with the past is yet another sign that the markets’ close dependence – dare I say overdependence – on central banks’ utterances and actions was at least temporarily weakened during the quarter.”
In response to the deregulation and fiscal expansion promised by the new US administration under President Donald Trump, US stock markets have soared to new highs while 10-year Treasury yields hit a two-and-a-half year high of 2.6% immediately following the election.
Within stock markets, investors displayed greater discrimination, piling into reflationary sectors such as defence, construction and manufacturing, while import-intensive sectors lost ground over the quarter.
In the euro area, elections and expectations of QE tapering by the ECB also drove asset price divergence. Sovereign spreads in France widened in response to forthcoming elections. Ten-year OATs traded as much as 80bp wide of German Bunds, settling back to around 60bp wide at current levels.
TARGET2 imbalances increased during the quarter, in some cases exceeding levels seen during the 2012 sovereign debt crisis. Those imbalances were driven by a capital flight from ailing peripheral economies to markets perceived to be safer, such as Germany, Luxembourg and the Netherlands. This time, imbalances appear to have emerged as a by-product of the ECB’s asset purchase programme.
BIS analysts Raphael Auer and Bilyana Bogdanova note that many ECB purchases are conducted by national central banks located in other countries. For example, the Bank of Italy buys securities from a London-based bank that connects to the T2 system via a correspondent bank in Germany.
“The purchase amount is credited to the account of the German correspondent bank at the Deutsche Bundesbank, thus increasing the T2 surplus of the Bundesbank. Similarly the Bank of Italy’s T2 deficit widens.”
In December, the European Central Bank confirmed that it would slow the pace of monthly asset purchases to €60bn from €80bn starting in April. At the same time, it extended the duration of the purchase programme to December 2017, or beyond if necessary.
The BIS also notes ongoing tensions in China’s financial markets, where a liquidity squeeze contributed to a sharp increase in domestic bond yields. Pressure from capital flows has driven wild swings between onshore and offshore renminbi, creating a daunting task for policymakers as they grapple with the triple challenge of historically high indebtedness, large portions of the corporate sector indebted in foreign currency and growing internationalisation of the currency.
“Such tensions were just the latest reminder of a global economy that is struggling to find a safe passage towards a sustainable financial stress-free expansion,” said Borio. “In more ways than one, the long shadow of the great financial crisis is still hanging over us.” (Reporting by Helen Bartholomew)