Weakening Correlations Suggest Time to Diversify

As we know, risk correlations tightened up (became increasingly positively correlated) during the financial crisis, where we saw very many near-perfectly positive correlations (>=+0.80) among the major asset classes: AUDUSD and Gold; NZDUSD and SPX; USD and DJIA; and JPY and US Treasuries among others.

In recent weeks (especially since the 2Q’13), we’ve since seen these correlations break down – perhaps the NZDUSD relationship with U.S. equities and New Zealand equities best serves this example:

NZDUSD correlation breakdown with equities

NZDUSD correlation breakdown with equities

 

Why does this matter? When correlations tighten up towards being perfectly positively or negatively correlated, there’s little benefit to diversification. IE, there’s no reason to invest in the NZDUSD if I’m long a basket of equities/S&P 500 as it’s essentially the same trade already. However, when risk correlations break down, the benefits of risk diversification increase. IE, there’s reason to trade the AUDUSD if you are long a basket of equities/S&P 500 because it reduces overall portfolio risk (general Markowitz/modern portfolio theory).

Thus, equity traders may find it appropriate now to start looking for ways to diversify, or hedge, risk. For the better part of the past few years, the NZDUSD has had a strong positive correlation with equity markets at home and abroad – the NZX 50 and the S&P 500 recently saw 52-week rolling correlations against the NZDUSD above +0.80 early in the 2Q’13.

As U.S. yields have risen thanks to a less dovish Federal Reserve and overall strengthening economy, the strong NZDUSD-equities correlation has eroded. In fact, for the week ended September 6, the NZDUSD-S&P 500 correlation fell to -0.47 and the NZDUSD-NZX 50 correlation fell to -0.35. This means the New Zealand Dollar may have some value as a speculative investment vehicle going forward – it retains yield despite losing correlation with equity markets. Recall from an earlier post that the New Zealand Dollar has seen increasingly strong yields:

NZD-USD Yield Spread versus NZDUSD fx rate

 

By reducing your profile’s overall correlation, you actually stand to reduce risk to your overall portfolio and capture greater returns. Now may be the right time to hedge away equity risk – by diversifying into the New Zealand Dollar, the highest yielding major currency alongside the Australian Dollar.

 

 

 

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