Fragmentation of Risk-on/Risk-off Matrix

By Marc Chandler

One of the most important developments in the foreign exchange market is the fragmentation of the risk-on/risk-off matrix that was a key feature since the onset of the financial crisis. While cognizant of the non-linear nature of the capital markets and the fact that returns are not normally distributed, we continue to find use in monitoring the correlation between individual currencies and the US S&P 500. Numerous portfolio managers we talk to also watch these closely.

The break down has taken place over a range of currencies and we summarize the developments here. The correlations are calculated on the basis of the percent change in the foreign currency and the percent change in the S&P 500 on a rolling 60 day basis.

The euro’s correlation to the S&P 500 may be the most closely followed. In early December the euro’s correlation made what appears to be a record high just below 0.86. It now stands near 0.45. The correlation over the past 30 days has stands near 0.42, indicating a even weaker relationship more recently.

The yen’s correlation with the S&P 500 reached a 7-year high in mid-January of around 0.42. The relationship is now inverse, with the 60-day correlation now at about -0.11.

The Australian dollar and Canadian dollar’s correlations with the S&P 500 have also come off sharply, but remain comparatively high. The Aussie’s correlation stands at around 0.71 now, down from the peak of 0.92 at the end of December. The Canadian dollar’s correlation has fallen from 0.90 in mid-December to 0.68 now.

We looked at a couple emerging market currencies to see if the break down of the risk-on/risk-off matrix extended outside of the majors and sure enough it did. The Mexican peso’s correlation has fallen from about 0.84 just before Xmas to 0.62 now. At the same time, the South African rand’s correlation has fallen from a little above 0.86 to about 0.61 now.

To round out the exercise, we took a quick look at gold. Gold is seen as the ultimate safe haven and yet it often is positively correlated with the S&P 500, a risk asset. This is the case now. Since the middle of November (even though the European debt crisis was intensifying), gold has been positively correlated with the S&P 500, giving the sense that gold is acting more as a momentum trade than a safe haven. The recent peak of the correlation was in late January near 0.63, which was the highest since April 2010. Today it stands near 0.30.