Seven separate assets currently maintain an 85% correlation (or better) with the S&P 500 over the last six months.
This correlated group includes Reuters/Jefferies CRB Index, emerging-market bond spreads, and not surprisingly, the euro. I’ve been talking about the tight correlation between currencies and stocks for some time.
My reason is simple: As risk ebbs and flows, the amount of traders buying U.S. dollars also ebbs and flows - only in an opposite direction.
So that means, when the S&P 500 tested new lows and bounced sharply, the U.S. dollar did the opposite - the dollar tested new highs and fell back sharply. We watched this happen this past week. Then on Thursday stocks collapsed again. Stocks tumbled to new lows not seen since 2003, and dragged down the euro right alongside. Of course, the U.S. dollar index broke out to a new high.
These tight correlations often are simply risk, ebbing and flowing. But maybe we should look deeper to understand the true driving forces behind recent trends. If you look closer, you can see why these correlations are more dollar-bullish than you might think.
What “Tight Coupling” Really Means
Over time, the market process can consistently produce extremely efficient interaction among human beings in the marketplace, in the business place and in life.
I try to make it sound simple. I try to boil it down to the big ideas. But really the entire process and all that goes into it is extremely complex.
I’m in the middle of a book by Richard Bookstaber titled Demon of Our Own Design. He’s devoted an entire chapter to an idea known as “tight coupling.”
That idea alone explains the correlations I just mentioned. Tight coupling also explains why the financial system crumbled, why the global economy is sinking, and why the U.S. dollar is back in vogue.
Tight coupling is the design and labor that goes into building a house. Tight coupling is how rock climbers scale a mountain-side. Tight coupling is an idea that helps to explain the detailed processes that go into complex, everyday functions. It also explains why disruptions of these detailed processes can happen.
Tight coupling exists throughout the financial markets that currency traders stress over nearly every single day.
A good example would be the recent subprime-mortgage backed securities fiasco. Before the entire credit system went boom, there were quite a few things strung tightly together. These things supported the trend of issuing subprime mortgages, bundling them up with other assets and selling them to investors.
But then home prices started falling. Suddenly borrowers couldn’t afford loans. Bundled loans became less attractive. The market for this newly created product froze up. Losses started piling up for investors in these bundled assets.
And then investors isolated from these assets began losing on their investments. This happened as the tightly coupled financial industry became unwound and asset values of good assets and bad began deteriorating together.
‘Propagate’ is a good word here - it means to cause to spread out and affect a greater number. Bookstaber used this word on occasion to explain how market participants add to the complexity of the financial system, and how that can lead to accidents which can trigger a vicious downward spiral of asset prices.
And that’s all well and good. Even if you’ve not yet grasped the idea of tight coupling yet, you understand what’s happened with the subprime market by now. You also know that relatively solid assets have been impacted once subprime derivative participants, and the market, were no longer able to handle the complexity of what they created.
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July 31st, 2009 at 1:52 pm
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