Thursday February 16

Indices were mixed today as the S&P 500 snapped its seven day gain streak. The S&P 500 fell 0.1% to 2,347 and the Dow Jones rose less than 0.1% to 20,619. The KBW Bank index fell 0.5% and utilities rose 1%. Economic data today showed continuing positive signs on jobless claims. Data this week has been positive and pointing towards inflationary pressures. Additionally FOMC members this week have made comments that can be interpreted as hawkish. Even in spite of those pressures rates fell. The two year Treasury yield fell 5bp to 1.21%. The ten year Treasury yield fell 5bp to 2.45%. 2yr vs 10yr remained at 1.24%. The dollar was weaker on the day against peers. USD fell 0.6% against EUR to $1.0674. USD fell 0.8% against JPY to Y113.26. USD fell 0.2% against GBP to $1.2487. Oil prices fell while gold rose 0.6% on lower interest rates. WTI rose 0.6% to $53.41. Brent fell 0.1% to $55.70.

Over the last few months correlations have broken down across asset classes. In the aftermath of the financial crisis and as a result of low volatility in markets correlations between asset classes rose. That means that bonds, stocks, currencies, and commodities in many cases moved in the same, predictable directions. Since reaching a peak of close to 50% in late 2015 cross asset correlations have fallen to around 25% currently. Similarly within asset classes such as global stocks, EM stocks, large cap equities, and different bond and commodity sectors correlations have dropped since QE ended. It is relatively easy for passive strategies to produce returns when assets are heavily correlated however now that markets are decoupling some analysts predict it will get more difficult. However fund flows are still migrating out of active and towards passive. Active managers could make a comeback as markets become less efficient. Asset allocation and security selection will begin to matter more as markets become less synchronized. To exemplify high correlations, between 2008 and 2014 global, U.S., emerging market stocks and high yield bonds all returned 15% annually. At the same time metals, EM debt and IG debt all returned 8% annually. As an early indicator of this since September active global allocation funds have returned 1.6% while passive funds have just returned 0.06%.

Investors are complaining that there is a scarcity of safe assets in financial markets. As a result of quantitive easing as well as new regulations on certain markets there are less safe assets available for investors. Increases in margin requirements in the form of cash held at clearinghouses have partially caused this problem. Clearing houses don’t want to hold those funds as cash in deposit accounts so instead they bring it to the repo market. Clearinghouses are only allowed to leave 5% of their cash in deposits. They essentially engage in repo transactions when they make a short term loan and receive a high quality bond as collateral and earn the repo rate. These types of transactions are used to finance trading and investing activity in almost all developed markets all over the world. However it has led to a shortage of safe bonds for investors to use. As a result some regulators fear that instead investors must come up with alternatives to government bonds which is how bubbles and misallocation of assets starts. Data from the BIS shows that this problem is especially evident in Europe as demand for collateral has doubled recently. Clearinghouses are also responsible for the problem because they have guarantee funds in the event of defaults and those need to be invested in safe assets. Repo rates are spiking as a result of this development and settlement failures for repos last year hit the highest level since 2008.

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Thursday February 16

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