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Negative or Positive Correlations

Discussion in 'Market Predictions and Reports' started by dojit, Jan 11, 2009.

  1. dojit

    dojit Private

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    Negative or Positive Correlations
    Sunday, January 11, 2009
    By dodjit
    Since the first interest rate reduction in the U.S, central banks have been battling ongoing problems, trying to stay ahead, in order to prevent further economic blows. From the U.S, economic problems quickly spread throughout the globe, making investors realize that today’s relationships between global economic markets are much stronger than previously thought. Expectations of a stock market collapse in the U.S during 2007 led to a 40% drop on the U.S major indices while other major indices across the globe followed almost instantly, with the same type of price movement. On the currency market, similar price movements were also experienced as central banks simultaneously made their rates less appealing, forcing investors to seek alternative routes; ones that were yielding much higher returns. Taking a walk down history lane, one can see that correlations between various securities are a quite common, especially as officials take equal measures to try to control their economies.
    Positive correlations can often be seen during stable markets as monetary tightening is used to control expanding economies (a time when securities tend to correlate and rise), while monetary easing is implemented to control a rapid contraction.
    A major question that arises is what happens to those positive correlations on various securities when the markets are in turmoil and central banks are not taking equal measures. Do those securities lose their positive correlations?
    Over the years, the European Central Bank and the Bank of England have stuck to a firm policy, keeping their central rates high against fellow banks. Their high yielding rates gave their currencies the upper edge against counterparts like the U.S, allowing their domestic currencies to strengthen against the U.S Dollar.
    The 2008 recession sent the markets into mayhem, forcing rapid movements on the currency market. Strong currencies like the Euro and Pound dropped against their counterparts while a weak Yen surged. Taking a glance at the price chart below, one can see the positive correlation between the Euro and the Pound. Both outperformed up until the end of 2007 and both fell due to the economic situation throughout 2008.

    Could that positive correlation now be weakening due to central banks’ different stances? Have we already witnessed a similar situation in the past?
    From the end of 2007 throughout the beginning of 2008, the Euro continued higher while the Pound began to drop in value (negative correlation). Euro strength was caused by the ECB’s adamant stance to maintain a high interest rate, to control ongoing inflation. On the chart below, one can see that even though the Pound managed to hold on to its strength, the Euro outperformed it, weakening the correlation between the two. Only during July 2008 did the two regain their positive correlation, dropping against the U.S Dollar.


    While both economies have been dealing with contraction, deflationary pressures and high unemployment, the Bank of England has engaged in this economic battle using much more drastic measures. The ECB on the other hand, has been reluctant to follow suit, thinking twice before each rate cut. Even though the Euro-zone is in a massive slow-down, according to recent economic data, the U.S and England are still situated in more severe situation. In England, economic growth has gone down the drain, while the financial system is on the verge of a collapse. The Bank of England has engaged in massive rate cuts, recently reducing their central rate to its lowest level since the bank was founded in 1694. Low rates throughout 2008 made the Pound one of the worst performing currencies.
    By taking a glance at the following chart one can see that the correlation between the two has recently weakened. The End of year rally in the Euro caused by expectations that the ECB could refrain from cutting interest rate in January, now seems to be wearing off, and will surely be tested this up coming week. Dealing with problems in numerous economies and Germany showing unemployment shy off of 9%, the ECB might have no alternative other than to change its adamant policy taking similar actions to the BOE’s. Although the markets are still facing many risks, with expectations of a global recovery throughout 2009 and the Bank of England leading the race in rate cuts, could England outperform while others try to catch up? On the currency market, will the Pound outperform the Euro this time round, due to the BOE’s pro-activity?


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