The U.S. dollar’s correlations with equity benchmarks, yield differentials and the overall yield curve are plotting a rare pattern, which hasn’t been a good omen in the past, says BNY Mellon’s chief currency strategist Simon Derrick.
While history is far from a perfect guide, “it seems worth highlighting that the levels of correlation currently being seen between the dollar index and key U.S. asset markets have previously been associated with either the run up to or the aftermath of major market events,” Derrick said. Importantly, Derrick notes, they don’t usually appear at the same time and for this long.
So which correlations is he talking about?
The current 200-day rolling correlation for the tech-heavy Nasdaq Composite
and the U.S. dollar index
is -74.8%, said Derrick. Similarly, the Dow Jones Industrial Average
and the greenback sport a -74% correlation, while the metric against the S&P 500
comes in at -73.9%.
A correlation of -100% would mean that a pair of assets are perfectly negatively correlated, meaning that a move higher by one asset would be matched by an equal move lower by the other asset. A correlation of 100% would mean the two assets move in lockstep in the same direction.
Meanwhile, the correlation between the dollar and the yield curve, the spread between the yields of shorter-dated and longer-dated U.S. government debt, is strongly positive. The correlation between the dollar and the 2-year
Treasury yield curve, for example, stands a 68.8%.
The correlations between the buck and “outright Treasury yields are catching up rapidly with both groups with the number against the 2-year at -65.6%,” Derrick said. That means the dollar tends to weaken when the 2-year government bond’s yield
and to a slightly lesser degree those of its longer-dated cousins, go up.
“It is rare for correlations of this strength to appear collectively for any length of time,” said Derrick. “Indeed it happened just three times over the past 40 years.”
The first was in late 1978, according to Derrick, in the “latter stages of two-year old dollar downtrend fueled by lax U.S. monetary policy.” That sounds familiar.
“The three-month period that correlations reached the extremes currently registered coincided with the dollar finding a base as the Federal Reserve continued to tighten and culminated in a 15% slide in the S&P 500,” Derrick said.
Another instance of the triple-threat correlation happened in the summer of 1987, when the dollar was trending lower following the Plaza Accord, an foreign exchange policy pact that had the U.S., U.K., West Germany, France and Japan agree on devaluing the greenback. The correlations remained in place marked by a hawkish Fed, a sudden inflation pickup, and a rally in the S&P 500, which came to a screeching halt on Black Monday in October of that year.
Finally, there was a third instance between December 2008 and May 2009, when the world found itself in the global financial crisis.
“This differs from the previous two episodes in that it came after, rather than before, a major stock market slide,” said Derrick. “However, it remains interesting that it was again connected with a period of market turbulence.”
On Monday, U.S. equity benchmarks got slammed, with the Dow falling more than 4%, while the CBOE Volatility Index
rose to a level not seen since the Brexit vote in June 2016.
Read: Stock-market volatility surges, but VIX traders aren’t panicking yet
Also read: A ‘Powell put’ for the stock market? Don’t even think about it