Patterns of financial crisis: EUR/USD, Deutscher Aktien and the Dow, 2007-2009.

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Written by Forex Automaton   
Wednesday, 25 February 2009 13:07

I continue with the index-1/index-2 vs currency-1/currency-2 correlation methodology. Today's post is about correlations between DAX/DJIA (the ratio of Germany's and US' blue chip indexes, Deutscher Aktien IndeX and the Dow) and EUR/USD.

With the ratios costructed this way (symmetrically), the null hypothesis would be to expect a negative correlation: the value of dividend-generating assets such as stocks is negatively correlated with the cost of money, even without stock market bubbles in the picture, but especially when such bubbles are part of the picture. As before, I work with logarithmic returns, therefore it's irrelevant in what units the quantities are expressed (that is how these indexes are defined and what absolute magnitude they typically assume).

EUR/USD chart from August 2007 through January 2009, day DAX/DJIA chart from August 2007 through January 2009, day

Fig.1:Top: EUR/USD chart, day scale. Bottom: DAX/DJIA (day close) evolution. Time axis is labeled in MM-YY format and spans the interval from August 2, 2007 to February 12, 2009.

Time evolution of the structure of the EUR/USD and DAX/DJIA correlation peak, day scale, from August 2, 2007 to February 12, 2009. Negative lags. Time evolution of the structure of the EUR/USD and DAX/DJIA correlation peak, day scale, from August 2, 2007 to February 12, 2009. Positive lags.

Fig.2: Evolution of the correlation between EUR/USD and DAX/DJIA  during the financial crisis, day time scale. The peak structure is represented by three correlation values: the one for the zero lag (essentially a volatility measure), the one at (plus or minus) one day lag and the one at (plus or minus) two day lag. Negative lags are in the top panel, positive lags -- in the bottom panel. Time axis is labeled in MM-YY format and spans the interval from August 2, 2007 through February 12, 2009, with two-week wide bins.

As before, I define the visible phase of the present financial crisis to begin on August 16, 2007, the day of Countrywide Financial near-bankruptcy event, followed by an extraordinary half-percent Fed discount rate cut next day. This study covers 80 weeks from August 2, 2007 through February 12, 2009. Fig.2 shows the time evolution of the correlation peak by plotting the correlation values for the negative and positive lags in separate panels.

Overall for the period, looking at same day (zero time-lag) data, DAX/DJIA is seen to be positively correlated with EUR/USD -- in contrast with what was said about FTSE/DJIA and GBP/USD, despite the latter analysis being fully analogous in terms of technique.

The time lag is defined as

td = t1 - t2,

where index "1" denotes EUR/USD and index "2" denotes DAX/DJIA. Therefore, positive correlation values at negative lags mean that movements of the same direction in EUR/USD and DAX/DJIA happen at an earlier time in EUR/USD, or EUR/USD is a leading indicator for DAX/DJIA. Negative correlation values at negative lags mean that movements of the opposite direction in EUR/USD and DAX/DJIA happen at an earlier time in EUR/USD, or EUR/USD is a leading indicator for DJIA/DAX (note the difference with the previous sentence).

Looking at the top plot of Fig.2, we find both kinds of situations, alternating with comic regularity during the volatile Fall of 2008. There seemed to be one thing you could pretty safely bet on: the correlation value at -1 day lag was going to have an opposite sign to the "instantaneous" (0 lag) correlation between the two indicators, no matter what this sign is.

For the forex trader, the bottom panel of Fig.2 is more interesting as it deals with potential leading indicator for EUR/USD. More often than not and when it matters (that is when the volatility is high) we see negative one day lag signal, meaning that movements of the opposite direction happen in EUR/USD one day after DAX/DJIA.

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Last Updated ( Monday, 04 January 2010 12:39 )