Cross-Asset "Contagion" Risk Indicator Worse Than Lehman

Nowhere else is the impact of central banks more evident than the total decoupling of global stock markets from global economic developments.

However, Bloomberg reports that as money managers attempt to diversify away from what they all know will not end well, Credit Suisse warns the overwhelming flow from central bank interventions "are driving everything" pushing their so-called cross-market contagion indicator to levels more worrisome than anytime since 2008's Lehman-inspired financial crisis.

Massive central bank stimulus with below zero rates and quantitative easing has led to increasingly dysfunctional markets, with even the negative correlation between stocks and bonds breaking down. As we have noted previously, they are now largely moving in the same direction as markets have become more driven by central banks, leaving investors with no place to hide. 

And short-term (intraday) bond-stock correlation has spiked near record highs...


And as Bloomberg notes, the Credit Suisse data, which tracks price relationships in equities, credit, currencies and commodities, shows that different markets are influencing each other in 2016 at a higher rate that any time since the measure was invented in 2008. The indicator assesses how much movements in one market are statistically explained by movements in another.

The data illustrate the interconnections among global markets and may reflect the growing impact of central bank policy on prices. An increase in correlations is fodder for skeptics who look at declining U.S. earnings and rising valuations and argue that the only explanation for record highs in U.S. stocks this summer is Federal Reserve policy.


“Rates are driving everything,” Mark Connors, Credit Suisse’s global head of risk advisory in New York, said by phone. “At a minimum you have to be aware of the influence of central banks. What’s moving the market is people’s demand for yield and return. Fundamental analysis doesn’t explain the movement higher from here.”


Credit Suisse keeps track of the performance of various assets through 21 exchange-traded funds and employs a model called principal component analysis to define the degree to which markets are influencing each other. Its contagion index reached a record 75 percent  in late June after the U.K. decision to exit the European Union.


While the gauge has since slipped, it’s still averaged 65 percent this year, climbing for a second year after bottoming at 57 percent in 2014. Treasury and investment-grade bonds, securities mostly sensitive to fluctuations in interest rates, have been the highest-influence asset classes in 2016.

The elevated level of cross-asset correlations highlights the danger of simultaneous selloffs should central banks tighten. But what’s more troubling is the potential for violent swings in the inter-market relationship that could make it harder for quantitative funds to adjust, according to Marko Kolanovic, the New York-based head of global quantitative and derivative strategy at JPMorgan... (as we detailed previously)

As market volatility plummeted, investors added to option protection and moved (struck) it closer to current price level. The market would need to move only 1-2% lower for option hedging to push volatility higher (as opposed to suppressing it, which was the case past 2 months). Given the low levels of volatility, leverage in systematic strategies such as Volatility Targeting and Risk Parity is now near all-time highs. The same is true for CTA funds who run near-record levels of equity exposure. Our estimate of equity exposure for these strategies is shown in Figure 1.




Record leverage in these strategies and option hedging could push the market lower and volatility higher, if there is an initial catalyst to increase volatility. In fact, we may not even need a specific catalyst, apart from the seasonal increase in market volatility which is typical for September and October. Figure 2 above shows that equity volatility tends to increase by ~20-30% in September and October  (September also tends to be the worst performing month, with an average -1% return). This seasonality is also present after removing prominent outliers (e.g. 2001, 2008, 2011, and 2015). When it comes to deleveraging of systematic strategies, even this seasonal increase in realized volatility would produce outflows of ~$100bn, which could push the market lower.


It seems that equity long-short investors are already anticipating a potential weak September, as their equity exposure (equity beta) declined over the past month. The low exposure of long-short hedge funds, and the fact that equity momentum would only turn fully negative below ~2000 on the S&P 500, are the only two positives we see for the market going into September.

So what is Marko's recommendation for those who wish to avoid what may be another significant spike in volatility?

Clients who want to hedge levels of cross-asset correlation can invest in gold – over the past 10 years, gold returns were ~45% correlated to changes in cross-asset correlation (Figure 3).