Harry Tchilinguirian at BNP Paribas observes the curious breakdown in correlation between oil and equities of late:
As can be seen, the last time there was as sharp a breakdown in the correlation was in the fourth quarter of 2008 — after which a period of extended correlation was observed.
Much of that, Tchilinguirian argues, was down to the effects of quantitative easing. Or as he explains:
While the positive correlation in oil and equities at the end of 2008 and early 2009 (Chart 3) may have been considered spurious, the relation endured post the first round of QE easing as the Fed sought to reflate the economy. Ultimately in early 2009, talk of deflation dominated the economic headlines and the purpose of QE was to inflate asset prices from their depressed levels.
The Fed wanted to avoid at all cost an economic scenario of simultaneously declining output and prices. The move of cash holdings into risky assets lifted stock valuations and provided a boost to the price of a number, but not all of commodities. Over 2009-2010, oil and equities maintained a positive correlation in their daily returns in the vicinity of 60%. US dollars were not domestically confined; in 2009, they turned to foreign equity markets as well, contributing to a rise in foreign reserves, notably of Asian countries, and resulting in a weakening of the currency of international transactions . USD-denominated commodities that trade inversely to the strength of the currency found in this development a further leg of support to their price.
Of course, with regards to the uniquely correlated relationship between oil and equities, there were other factors at play too he says:
If increased liquidity and ensuing dollar weakness were strong contributing factors in establishing cross-asset correlation in the context of rising risky asset prices, there were also specific factors in the oil market that we believe, enhanced this relation.
In particular, the availability of inexpensive floating storage in the form of very large crude carriers, made idle by the recession and the drop in oil demand, allowed the storage of excess oil. With the marginal barrel kept off the market, the oil price was more responsive to increased liquidity conditions. Similar sensitivity was seen for certain base metals as low interest rates afforded cheap finance to build-up inventories in LME and non LME warehouses alike. In contrast, US natural gas did not have alternative storage to mop the excess supply sourced from shale and fell victim to its fundamentals. NYMEX Henry hub prices did not develop a correlation with equities, but weakened and disconnected on a BTU basis from oil.
From that perspective, the key question now is just how long is the current breakdown in correlation likely to last?
In Tchilinguirian’s opinion, all indications suggest a good while since the tensions in the Middle East have now taken over many of those previous effects.
With the advent of events in the Middle East and resultant higher oil prices, the correlation in daily returns between oil and equities has come undone. Is this temporary? A couple of considerations suggest that this might not be the case.
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The disparity in volatility and skew suggests intuitively that daily returns between oil and equities are susceptible to divergence and for now less correlation.
Of course, there’s nothing like a little QE3 to potentially re-align matters if and when tensions in the Middle East do dissipate.
In which case, it’s probably best never to say never to the return of correlation.
Related links:
Oil facilities on fire - FT Alphaville
Bahrain’s strategic importance, graph du jour – FT Alphaville
Why you really can’t swap Libyan crude for Saudi – FT Alphaville
Life in the Gaddafi oil market - FT Alphaville
Oil shock 2.0, or, the benchmark wars – FT Alphavill