Patterns of financial crisis: EUR/USD, CAC-40 and the Dow

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Written by Forex Automaton   
Wednesday, 04 March 2009 16:05

From the two cases considered so far in the index-1/index-2 vs currency-1/currency-2 correlation technique (correlating FTSE/DJIA and DAX/DJIA with EUR/USD), one common feature is evident: one-day lag correlation "prefers" to have an opposite sign to the "instantaneous" correlation. Today's post is about correlations between CAC/DJIA (the ratio of France's and US' blue chip indexes, Cotation Assistee en Continu 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. However, if international capital flows are taken into account, one would have to distinguish between low-interest and high-interest currencies. A scenario is possible where both value of the stock market in country A and the national currency of the country can be inflated by cheap money originating in country B. The case in hand may not be a good example of this. The point however is that such a mechanism would invalidate the reasoning behind the "null hypothesis".

As always on this site (and in contrast with most of the available literature) the emphasis is on correlation values at non-zero time lags, since these, when non-zero in a regular way, indicate technical predictability of the markets -- at least in principle.

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 February 2009, day CAC/DJIA chart from August 2007 through February 2009, day

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

The time evolution of both time series under study, EUR/USD and CAC/DJIA, is show in Fig.1. 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.

Time evolution of the structure of the EUR/USD and CAC/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 CAC/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 CAC/DJIA correlation peak structure 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. See text for definition. 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.

Overall for the period, looking at same day (zero time-lag) data, CAC/DJIA is seen to be positively correlated with EUR/USD, similarly to DAX/DJIA, and in contrast to FTSE/DJIA. The main events contributing to make this correlation positive are the stock market mini-crash of January 2008 (much stronger in Europe) and the volatile second half of September 2008.

The time lag is defined as

td = t1 - t2,

where index "1" denotes EUR/USD and index "2" denotes CAC/DJIA. Therefore, positive correlation values at negative lags mean that movements of the same direction in EUR/USD and CAC/DJIA happen at an earlier time in EUR/USD, or EUR/USD is a leading indicator for CAC/DJIA. Negative correlation values at negative lags (top panel, January 2008) mean that movements of the opposite direction in EUR/USD and CAC/DJIA happen at an earlier time in EUR/USD, or EUR/USD is a leading indicator for DJIA/CAC.

For the forex trader, the bottom panel of Fig.2 is more interesting as it deals with potential leading indicator for EUR/USD. Negative correlation values at positive lags (look at the bottom panel of Fig.2, Fall 2008) mean that movements of the opposite direction in EUR/USD and CAC/DJIA happen at an earlier time in CAC/DJIA, or CAC/DJIA is a leading indicator for USD/EUR.

Speaking of stable patterns, clearly the negative bunch of 1-day lag correlations in the bottom panel during the Fall of 2008 is more than a random coincidence. So is the tendency for the 1-day lag correlation value to be of an opposite sign to the "instantaneous" (lag zero) correlation value.

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