When things start to get scary in the financial markets, investors and traders have a tendency to dump securities indiscriminately.
This is observed when the prices of securities, despite industry-specific and company-specific characteristics, fall across the board. In the industry, this is referred to as risk-on/risk-off behaviour.
The degree to which securities move hand-in-hand is measured by correlation. A correlation closer to +1 implies more of a dollar-to-dollar move in prices.
According to a new study from the IMF, correlations in general are much more elevated these days than they were before the financial crisis. In other words, there are fewer places to hide in the markets when the markets start tanking. Check out the red bars in the chart.
In its new Global Financial Stability Report, the IMF discusses correlations in a section title “When Market Liquidity Vanishes,” a read that’s been described as “not for the faint-hearted.”
“Correlations among risk-adjusted returns of major asset classes have increased markedly since 2010,” the IMF writes. “The correlation of the S&P 500 with U.S. high-yield indices has shown a steep increase, and the correlation with commodities has increased fourfold. The substantial rise in correlations between asset markets in advanced and emerging market economies points to an increased possibility of contagion or spillovers in periods of stress.“
In short, contagion means that bad things affecting one part of the economy or market is affecting other parts of the economy or market.
The IMF argues these elevated correlations only increase the urgency for which regulators address potentially destabilizing market events.
“The increase in correlations during stress periods suggests greater risks of contagion across asset classes or borders,” they continued. “It also points to the importance of liquidity as an amplifier of other risk factors. Consequently, policies that address the sources of low liquidity should be seen as part of a comprehensive financial stability framework.”