GBP/USD, GBP/JPY Price Action Ideas Post UK Inflation Release

Economic

Forex

Summary:

The GBP received a shot in the arm this morning owing to an uptick in UK inflation data. Market participants immediately repricing their rate cut expectations down to around 59 bps through December 2025, from a previous 65bps.

UK Inflation Challenge

The UK continues its battle with inflation, and more importantly services inflation which ticked up slightly from September with a print of 5% vs the prior month’s 4.9%. The increase in headline inflation might also be a concern now as the annual inflation rate rose to 2.3% in October 2024, the highest in six months, compared to 1.7% in September.

Markets were expecting an uptick in headline inflation to around 2.2% while the MoM inflation number came in at 0.6% above the estimated 0.5% as well. The concern however remains with the service inflation number which is keeping headline inflation elevated.

Looking more closely at the data and a lot of the stickiness in the October number comes from categories that the Bank considers less important or less likely to show lasting inflation. This would include things like rent, airfares and package holidays which could in part explain the uptick in services inflation.

A good example of this is when looking at the core services inflation which strips out the data of rent and airfare and we have an entirely different narrative. Given there is no single definition for this, however it has been aptly broken down by ING Think which showed the ‘core services number’ had actually dropped from 4.8% to 4.5% in October.

Source: ING Think

This does not change a thing for the BoE when it comes to the upcoming December policy meeting. I still expect a 25bs cut following the recently released GDP numbers from the UK. Growth is beginning to turn sour, much like the European Union. This is something the BoE would like to avoid and in my opinion may factor heavily at the December meeting.

Based on probabilities, market participants are now pricing in around an 85% chance of a hold at the December 19 meeting with a possible rate cut in February given a 50% chance. This should in theory lend some support to the GBP as the US is expected to cut in December and the Bank of Japan is likely to continue hiking rates in 2025. Will such a move and a GBP recovery come to fruition?

Technical Analysis

GBP/USD

From a technical standpoint, GBP/USD rose in the early part of the week but failed to hold onto any material gains. The weakness in the US Dollar Index did not yield any significant gains for the GBP and with the DXY looking at a recovery today, Cable may face further downside pressure.

At present the key level around the 1.2680 handle is proving a tough nut to crack with UK inflation data helping the GBP/USD to break above this level but failing to find acceptance. If a daily candle close above this handle occurs, bulls may be emboldened which could push cable higher.

A move above the 1.2680 handle may face resistance at 1.2750 and 1.28200 (which is where the 200-day MA rests). The next key hurdle for bulls will be the 1.3000 psychological level which may prove to be a hurdle too far.

Looking at the potential for a break to the downside and the most recent swing low at 1.2600 will be the first area of support before the 1.2500 and 1.2450 handles come into focus.

The driving force behind any move is likely to come from the US Dollar Index (DXY) and its performance in the coming days. Further US Dollar strength could facilitate a retest of the 1.2500 handle.

GBP/USD Daily Chart, November 20, 2024

Source: TradingView.com (click to enlarge)

Support

1.2600

1.2500

1.2450

Resistance

1.2680

1.2750

1.2820

GBP/JPY

GBP/JPY has been inching its way lower since topping out just shy of the psychological 200.00 handle. A pullback helped yesterday by renewed safe haven flow also helped GBP/JPY push further away from the 200.00 handle.

Looking at the technicals and we have some mixed signals. We have a death cross formation as the 100-day MA crossed below the 200-day MA hinting at downside momentum. The candlesticks on the other hand show a sharp rejection following the brief stint below the MAs yesterday with the daily candle finishing as a hammer candlestick hinting at further upside.

The mixed signals do not make it easier, however when combining this with the fundamentals, further upside seems more likely in the short-term. The question is will the 200.00 handle prove a step too far for bulls?

A move higher from current prices for GBP/JPY could face resistance at 198 and 199.30 respectively.

A move lower will first require a daily candlestick close below the two MAs resting around the 194.30-194.60 range. A break of this zone could push GBP/JPY toward the 192.50 and 190.00 handles respectively.

GBP/JPY Daily Chart, November 20, 2024

Source: TradingView.com (click to enlarge)

Support

194.30 (200-day MA)

192.50

190.00

Resistance

198.00

199.30

200.00

Source: ACTIONFOREX

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Risk Warnings and Disclaimers

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Warren Takunda

Economic

Businesses are bracing for the economic impact of a second Trump presidency, which, if his campaign promises are to be believed, will mean tariffs across nearly all imports to the US, especially those from China.

But amid the gloom over the spectre of a renewed global trade war, some manufacturers may be looking to those who already have a playbook on dealing with aggressive US levies, such as China’s solar companies.

China all but owns the global solar market. Its share in every stage of the solar panel manufacturing chain exceeds 80%, according to the International Energy Agency. Last year it exported a record high of 227 gigawatts (GW) of solar panels – more than the entire installed solar capacity of the United States.

But virtually none of those panels were destined for the US. Less than 1% of the 54 GW of solar panels the US imported last year came from China.

More than a decade of US duties on Chinese solar cells and panels – which are expected to be ramped up further by Trump – have all but eliminated Chinese solar equipment from the US.

This has spurred some Chinese companies to rapidly shift and expand their supply chains overseas in what US government agencies allege is an attempt to dodge US levies – an alleged approach that may be setting an example for other manufacturers.

Because although less than 1% of the US’s solar imports come from China, more than 80% of them come from four countries in south-east Asia: Cambodia, Malaysia, Thailand and Vietnam. Last year, the US Commerce Department concluded that certain Chinese photovoltaic (PV) companies had been re-routing their supply chains through those countries in order to avoid US tariffs.

China’s major PV technology companies have been opening factories in south-east Asia since at least 2016. That year, the world’s third-largest solar manufacturer, Longi, expanded to Malaysia with its first overseas production base, and the launch of a Thai subsidiary. It also has a facility in Vietnam, and this year began construction of another Malaysian project and a joint-venture factory in the US. “The company’s shipment capabilities in the US market are expected to be enhanced,” it said in its 2023 annual report.

In 2022, Longi denied findings by the US Department of Commerce that a Vietnam subsidiary, Vina Solar, was among a number of Chinese companies circumventing tariffs by finishing products in south-east Asia, and said it was obeying US law.

But decision-makers in Washington see the expansions into south-east Asia very specifically as “an attempt to circumvent antidumping and countervailing duties”, said Cory Combs, associate director at Trivium China, a research company.

Longi denied the commerce department’s findings in 2022, and in its interim annual report this year said the “trade barriers” imposed on PV producers had “increased uncertainty” for companies, appearing to suggest that the global expansions were aimed at diversifying supply chains.

Last month, the commerce department announced new preliminary duties on several Chinese solar manufacturers that were exporting from Cambodia, Malaysia, Thailand and Vietnam. The decision follows a complaint from US solar panel companies that alleged Chinese companies were using their factories in those four countries to flood the US market with panels priced below their cost of production.

Longi was not among the solar manufacturers on the list, and it is not clear if the list includes one of its subsidiaries. Longi did not respond to repeated requests for clarification or comment.

Various US tariffs and antidumping duties have since been levied on the industry in the region at either country or company level, or in some cases both, and eyes are on the movements of Chinese industries.

Speaking generally, tariffs “are a bit like whack-a-mole”, said Marius Mordal Bakke, a senior analyst at Rystad Energy, a business intelligence company. As soon as import duties are targeted at one country, companies will up sticks and move to another. Rerouting supply chains costs money, “but as long as you can sell your product for three to four times as much in the US market, then it’s probably likely worth it.”

Next stop: the Middle East

The game of whack-a-mole now seems to be spreading to other parts of south-east Asia, such as Laos and Indonesia. In the first eight months of this year, US imports of solar goods from Indonesia reportedly nearly doubled to $246m, while shipments from Laos have also been surging.

The industry is also moving to the Middle East, said Combs.

“As south-east Asia gets hit harder and harder by these tariffs a lot of Chinese investors are moving into the [Gulf Cooperation Council, or GCC], particularly Saudi Arabia and the UAE and Oman. Does this happen quickly enough that the GCC becomes the next south-east Asia and then also gets hit with anti dumping and all that stuff? That’s already where the conversation is in DC.”

Chinese companies are well aware of the need to tariff-proof their businesses, and there are signs of plans being made to get ahead of Trump’s promised tariffs, on China and elsewhere.

Tongwei, China’s biggest solar company, said in its annual report that many Chinese photovoltaic companies have “started exploring new avenues for growth, including establishing manufacturing facilities overseas”, citing the US, the Middle East and Vietnam as examples, without elaborating on the company’s own plans.

The US solar market is relatively small. In 2023, it accounted for less than 10% of the solar panel global market, according to analysis by Lauri Myllyvirta, the lead analyst at the Centre for Research on Energy and Clean Air. Given over 93% of global production capacity for polysillicon – the raw material to make solar panels – is in China, it will be nearly impossible for the US solar industry to fully extricate itself from Chinese companies.

Indeed, the biggest risk to the Chinese solar industry from the incoming Trump administration may not be tariffs, but politics. “The solar industry in China has positioned itself to supply the solar equipment needed for a rapid global energy transition,” Myllyvirta said. “And it’s quite clear that the Trump administration is going to try and slow down that transition”.

Source: TheGuardian

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Risk Warnings and Disclaimers

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Warren Takunda

Economic

December Nasdaq 100 E-Mini futures are trending up +0.09% this morning as investors shifted their focus to a highly anticipated earnings report from AI darling Nvidia.

In yesterday’s trading session, Wall Street’s main stock indexes closed mixed. Super Micro Computer soared over +31% and was the top percentage gainer on the S&P 500 and Nasdaq 100 after the server maker appointed an independent auditor and submitted a compliance plan to Nasdaq. Also, Nvidia climbed more than +4% and was the top percentage gainer on the Dow after Stifel and Truist raised their price targets on the stock. In addition, Walmart rose +3% after the retail giant posted better-than-expected Q3 results and raised its full-year guidance. On the bearish side, Incyte Corp. slumped over -8% and was the top percentage loser on the S&P 500 after halting enrollment in a Phase 2 trial of its chronic spontaneous urticaria candidate targeting MRGPRX2 due to findings from preclinical toxicology.

Economic data released on Tuesday showed that U.S. housing starts fell -3.1% m/m to 1.311M in October, weaker than expectations of 1.340M. Also, U.S. October building permits, a proxy for future construction, unexpectedly fell -0.6% m/m to 1.416M, weaker than expectations of 1.440M.

Kansas City Fed President Jeffrey Schmid said on Tuesday that it remains uncertain how far interest rates can fall, although the initial cuts by the Fed are a sign of confidence that inflation is moving back to its 2% target. “The decision to lower rates is an acknowledgment of the ... growing confidence that inflation is on a path to reach the Fed’s 2% objective - a confidence based in part on signs that both labor and product markets have come into better balance in recent months,” Schmid said.

Meanwhile, U.S. rate futures have priced in a 59.1% probability of a 25 basis point rate cut and a 40.9% chance of no rate change at the December FOMC meeting.

Market participants are awaiting Nvidia’s third-quarter earnings report, scheduled for release after the market close, to gauge future demand for its new Blackwell AI chips, particularly after The Information reported on Sunday that these chips were experiencing overheating issues when connected to server racks designed to hold up to 72 chips.

“After an exhausting election cycle, options show that NVDA results will be the most important catalyst left for the remainder of the year, notable, more so than NFP, CPI, and FOMC,” Stefano Pascale, equity derivatives strategist at Barclays, said in a note Tuesday.

Prominent companies like TJX, Palo Alto Networks , Target , and Snowflake are also set to report their quarterly figures today.

On the economic data front, investors will likely focus on U.S. Crude Oil Inventories data due later in the day. Economists estimate this figure to be -0.1M, compared to last week’s value of 2.1M.

In addition, investors will be looking toward speeches from Fed Governors Lisa Cook and Michelle Bowman.

In the bond market, the yield on the benchmark 10-year U.S. Treasury note is at 4.417%, up +0.87%.

The Euro Stoxx 50 futures are up +0.42% this morning, partially rebounding from losses in the previous session as investors considered the geopolitical situation and looked ahead to Nvidia’s quarterly results. Construction and bank stocks outperformed on Wednesday. The Office for National Statistics reported on Wednesday that the U.K.’s annual inflation rate rose above the Bank of England’s target in October, suggesting that BoE interest rates are likely to remain higher for longer. Meanwhile, the European Central Bank cautioned on Wednesday in its semi-annual report that the potential for higher trade tariffs heightens the risk of rare but severe shocks to the global economy and poses a threat to financial system stability. In other news, a day after Russia lowered its threshold for a nuclear strike, Reuters reported that Russian President Vladimir Putin is open to discussing a Ukraine ceasefire deal with U.S. President-elect Donald Trump, easing geopolitical concerns. In corporate news, Sage Group Plc soared over +18% after reporting stronger-than-expected full-year operating profit.

U.K.’s CPI, U.K.’s Core CPI, and Germany’s PPI data were released today.

U.K. October CPI arrived at +2.3% y/y, stronger than expectations of +2.2% y/y.

U.K. October Core CPI came in at +3.3% y/y, stronger than expectations of +3.1% y/y.

The German October PPI has been reported at +0.2% m/m and -1.1% y/y, compared to expectations of -0.1% m/m and -1.1% y/y.

Asian stock markets today settled mixed. China’s Shanghai Composite Index (SHCOMP) closed up +0.66%, and Japan’s Nikkei 225 Stock Index (NIK) closed down -0.16%.

China’s Shanghai Composite Index closed higher today. Software and pharmaceutical stocks led the gains on Wednesday. China kept its benchmark lending rates unchanged at the monthly fixing on Wednesday, a move widely anticipated after a significant reduction in borrowing costs last month. Major Chinese banks maintained the one-year loan prime rate at 3.1% and the five-year LPR at 3.6%, according to a statement from the People’s Bank of China. Meanwhile, at an investment summit in Hong Kong on Tuesday, senior Chinese officials reaffirmed their commitment to progressing capital market reforms and further opening the financial sector to foreign investment. In other news, Chinese mutual fund houses announced on Tuesday a reduction in fees for their exchange-traded fund products, responding to authorities’ call to support the nation’s stock market. In corporate news, Beijing Kingsoft Office Software gained over +3% after its Hong Kong unit secured an advertising contract worth $7 million with Xiaomi’s Singapore arm. Investors now look ahead to China’s annual Central Economic Work Conference in December for potential additional stimulus measures to boost the economy.

Japan’s Nikkei 225 Stock Index closed slightly lower today as caution prevailed ahead of Nvidia’s earnings report. Automobile and insurance stocks led the declines on Wednesday. Data from the Ministry of Finance released on Wednesday showed that Japan’s exports rebounded more strongly than anticipated in October, driven by increased demand for chip equipment in China, although concerns persist about uncertainties in the global economy and U.S. trade policy. Also, data showed that Japan’s imports unexpectedly rose to a 3-month high in October. Meanwhile, investors are awaiting Japanese inflation data, set to be released on Friday, which is expected to provide further insight into the monetary policy outlook. In corporate news, Tokyo Gas soared nearly +13% after activist investor Elliott Investment Management disclosed in a regulatory filing that it had taken a 5.03% stake in the company. Also, Seven & I Holdings climbed more than +6% after Japanese broadcaster NHK reported that the founding family of the retail giant plans to finalize a deal to take the company private by the end of its fiscal year in February. The Nikkei Volatility, which takes into account the implied volatility of Nikkei 225 options, closed down -4.99% to 23.42.

The Japanese October Trade Balance has been reported at -461.2B yen, weaker than expectations of -360.4B yen.

The Japanese October Exports stood at +3.1% y/y, stronger than expectations of +2.2% y/y.

The Japanese October Imports came in at +0.4% y/y, stronger than expectations of -0.3% y/y.

Pre-Market U.S. Stock Movers

Keysight Technologies climbed over +9% in pre-market trading after the company reported better-than-expected FQ4 results and provided above-consensus FQ1 guidance.

Sangamo Therapeutics surged more than +12% in pre-market trading after announcing that the FDA had cleared the commencement of clinical trials for its drug candidate ST-503 in the treatment of intractable pain resulting from idiopathic small fiber neuropathy.

Powell Industries plunged more than -15% in pre-market trading after reporting weaker-than-expected FQ4 revenue.

Source: Barchart

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Risk Warnings and Disclaimers

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ING

Economic

Bunds in demand as Ukraine faces uncertain times

Over the past month, markets have rapidly adjusted to the realities of post-QE and QT. This is most evident in Bund swap spreads, but similar trends were also seen in the USD/EUR cross-currency basis, which has shared the same pattern as risk-premia into the looming year-end was reassessed. The shared trends suggest that concerns about German credit amid political instability were less influential, though they likely contributed to the overall movement.

Tuesday’s market reaction to headlines pointing to an escalation in the Ukraine conflict showed that the risk-off reflexes are still working. Bunds were the main recipient of safe-haven flows, outperforming other European government bonds with the 10y initially outperforming versus swaps by almost 4bp. The 10Y yield still sits slightly above swaps and time will tell how lasting the move will be or whether it is seen as an opportunity to jump back on the Bund underperformance trade. So far, the spread performance has been more resilient than the immediate reaction to headlines. However, recent history has shown that Bunds have had a weaker and shorter-lived response to risk-off events, such as the French election turmoil.

We still think that the levels broadly around 5bp above swaps could mark an equilibrium around which 10y Bund spreads evolve with risk-off episodes and supply as well as political turmoil continuing to add volatility. Recall that the equivalent spread of around 20bp above OIS was last observed in 2014 ahead of the European Central Bank's QE.

Today’s events and market view

UK October CPI data this morning came in hotter than expected with services inflation at 5% year-on-year and core CPI at 3.3% versus an estimated 3.1%. However, leaving out categories the Bank has told us it cares less about, our economist calculates that this "core-services" measure fell from 4.8% to 4.5%.

The data calendar remains lighter after the release of the UK CPI in the morning, although the ECB will release its indicator for negotiated wages in the third quarter today. A rise here, mainly given developments in Germany, is likely to garner some headlines amid markets that have become a tad more cautious about pricing aggressive easing from the ECB. We still think Friday’s PMIs will be key. Also look out for more commentary from ECB members, including de Guindos and Stournaras, while the ECB will also release its Financial Stability Review.

In primary markets, Germany will tap two bonds in the 30Y part of the curve for €1bn each. Later the US Treasury will sell a new 20Y bond for US$16bn.

To stay updated on all economic events of today, please check out our Economic calendar

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Warren Takunda

Cryptocurrency

Bitcoin’s potential climb to the $100,000 price level has captivated investors for years. While retail participants often celebrate such psychological milestones, the key impact should come from institutional adoption and advancements in the Bitcoin derivatives markets. Bitcoin to $100K: What Will Milestone Mean for Derivatives Markets?_1

Bitcoin to $100K: What Will Milestone Mean for Derivatives Markets?_1

Bitcoin futures aggregate open interest, BTC. Source: CoinGlass

Futures open interest on Bitcoin presently totals 626,520 BTC ($58 billion), a 15% increase in two months, signaling growing interest in derivatives. If Bitcoin reaches $100,000, this open interest would hit $62.5 billion, representing 3.1% of its $2 trillion market cap. This contrasts with the S&P 500, where $817 billion in futures open interest equals only 1.9% of its $43 trillion market cap.

A direct comparison between Bitcoin and S&P 500 futures is unfair, as over 65% of the cryptocurrency trading occurs on crypto-only exchanges such as Binance, OKX and Deribit. This number is expected to reduce as spot Bitcoin exchange-traded funds (ETFs) eventually launch their own futures markets, especially those offering in-kind creation that appeal to institutional investors.

However, regulation alone doesn’t guarantee adoption. For example, the CBOE offered Bitcoin futures from December 2017 to March 2019, only to discontinue the product due to low demand. Recent approvals for spot Bitcoin ETF options signal progress but underscore the need for deeper integration with traditional finance markets.

Institutional adoption: The key to $100,000 and higher

Institutional adoption is critical to translating Bitcoin's $100,000 milestone into meaningful derivatives market growth. Spot ETF options, for instance, could enable complex strategies like income generation through covered calls or hedging liquidity risks. As institutions grow more comfortable with Bitcoin as a reserve asset, the derivatives market will likely evolve to accommodate their sophisticated needs. Bitcoin to $100K: What Will Milestone Mean for Derivatives Markets?_2

Bitcoin to $100K: What Will Milestone Mean for Derivatives Markets?_2

Example of covered call expected return. Source: CME

Futures markets often confuse newcomers, particularly regarding the short positions. Many assume these positions signal bearish sentiment, but that’s not always the case. Strategies like cash and carry, where investors lock in a risk-free profit by selling futures while holding spot Bitcoin, create a large volume of short contracts. These strategies stabilize the market rather than betting on price declines.

A potential game-changing catalyst for Bitcoin's price surge could come from a shift in corporate governance. Microsoft shareholders recently voted to allocate funds toward Bitcoin, signaling a significant display of intention by influential investors. Even if the plans are not approved in 2025 or are disregarded by the board, the mere act of voting on Bitcoin allocation creates momentum that could pressure other companies to follow suit.

Additionally, Senator Cynthia Lummis’ proposal to convert US Treasury gold certificates into Bitcoin and create a “Strategic Bitcoin Reserve” offers another price catalyst. Her bill includes plans to acquire 5% of the total Bitcoin supply—1 million BTC—to be held for 20 years, further cementing Bitcoin’s potential as a reserve asset.

Bitcoin derivatives markets are a consequence, not a cause

Despite the excitement surrounding Bitcoin’s march toward $100,000, derivatives markets are more likely to react to broader adoption than drive it. Retail and corporate fears of fiat debasement remain the primary motivators pushing Bitcoin higher. This psychological shift—more than any futures product or spot ETF—will ultimately solidify Bitcoin’s role in institutional portfolios.

Lyn Alden’s research reinforces this narrative, showing a correlation between the global M2 money supply and Bitcoin's price. When governments accelerate monetary stimulus or reduce interest rates, investors increasingly seek scarce assets like Bitcoin as a hedge against debasement.

As a result, a liquid and mature derivatives market will emerge as a consequence, not a cause, of Bitcoin’s price breakthroughs.

Source: Cointelegraph

Risk Warnings and Disclaimers

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UBS

Economic

Diversification is the beating heart of any multi-asset portfolio. Assets that have low or negative correlation move in different directions and help smooth overall returns; one part of a portfolio offsets and provides ballast against others. Understanding correlations is therefore essential.

From 1950 to 2000 US Treasuries were positively correlated with equities – only for that to flip negative for the next 20 years. Recently, the relationship has turned positive again.

A number of questions flow from this. Is there something about the current regime that means historical correlation relationships will continue to break down? If so, what does this mean for asset allocation? And is achieving natural diversification going to get harder?

In the case of the latter, there are many reasons to believe it might be. From rising geopolitical tensions, extreme US debt levels, demographic reversals with structural implications for higher inflation, and the move to a more multi-polar world order (one perhaps less reliant on the US dollar), there are several seismic shifts happening.

Before conjecturing on what this might mean for portfolio diversification and while also acknowledging that the past is not prologue, we crunched the data in search of asset correlations lessons at various stages of the market cycle. The results confirm that the relationship between ’risk assets’ and ’safe assets’ is not linear.

Non-linear correlations

We analyzed monthly data for a variety of indexes in listed assets between August 1994 and September 2024; for robustness, we also looked at the wider range of index returns at the weekly data frequency, although for a shorter period due to data limitations.

The following illustration shows the behavior of the asset classes in our sample. The top-left chart, a histogram, shows the distribution of the first asset class (namely, US equities). The chart below it, a scatterplot, shows the returns of US equities (horizontal axis) against developed market equities excluding the US. Clearly, the two indexes tend to move together, with positive correlation. In fact, in the mirror-opposite cell of the matrix, we see r=0.84, meaning that the correlation between the two asset classes is 84%. We organized the charts in two panels, 2a and 2b, for readability.

Figure 2a has plenty of unusual patterns. The bottom line represents gold (vertical axis). Gold seems to have little correlation with the other asset classes, and indeed its scatterplots look like clouds, with no pattern emerging. This suggests that gold prices move independently from returns to the other asset classes, and therefore may be a candidate for diversification.

The following line is cash. Cash has different regimes, as confirmed by the histogram at the right-hand side of the bottom row. It shows a bimodal distribution – i.e., a histogram where there are two peaks (left for loose money, right for tight money), and a valley (intermediate monetary conditions, which do not appear to have happened frequently in the last 30 years).

The row of charts above cash represents macro hedge funds (alternative strategies focused on macroeconomic themes and taking concentrated bets on specific markets). The purpose of these strategies is to produce returns without material correlation to the markets in the long term and the results imply they do a pretty good job on average. The same is true for equity market neutral strategies which buy and sell similar stocks if one is expected to go up and the other down.

With commodities, the left-most scatterplot depicts commodities vs. US equities, showing that when equity markets go down (horizontal axis) commodity prices often seem to dampen the fall. However, observing the scale of the vertical axis as well as the histogram to the right, we notice that more than half of the monthly returns to commodities during our sample period were negative. This suggests that, while commodities are a diversifier, a passive buy-and-hold commodity allocation would have lost money over the last 30 years.

Emerging market debt (EMD) denominated in hard currency is on the following row. The histogram is noticeably narrow, indicating low volatility. The beta of the regression line for the scatterplot in the first column is also positive, showing that EMD returns were positive on average when US equity returns were positive, and vice versa. It is therefore hardly surprising that EMD is seen by the market as a risky asset.

Figure 2b is like 2a in the sense that the first row shows US equities, but the remaining assets are new. Let us look at them, again starting from the bottom row, showing developed government bonds excluding the US, which appear to have little correlation to risk assets. Credit, high-yield and investment-grade bonds specifically, are clearly risk assets with a positive correlation to stocks. US government bonds show a slightly negative correlation to risk assets during the last 30 years, and therefore have worked as mitigators of market volatility.

To complete the chart, we have equities from emerging markets and from developed markets excluding the US, which both have a strong positive correlation to the US stock market, showing the existence of a global business cycle.

Segments of market performance

By segmenting our sample to only consider months where equity performance was particularly negative, we can now look at responses in different market conditions.

For the chart above, we only consider months in our sample that were in the bottom 2.5% of the distribution – i.e., when the stock market did worse than 97.5% of the cases. All betas are positive except for that of cash, which is negative but close to zero. This indicates that when stocks fell dramatically in the last 30 years or so, cash tended to remain stable. The only other asset class with a small beta is US credit (investment grade) bonds, a relatively safe asset during market panics.

As Figure 3 shows, both US and non-US government bonds (typically a good refuge during market panics) and hedge funds stand out as these zero-correlation strategies duringmarket routs.

Repeating the exercise with different percentiles offers similar results. However, the beta for US government bonds goes from zero to negative. This suggests the hedging effect may be more substantial for government bonds when the stock market fall is less extreme.

The analysis carried out shows clear diversification benefits in multi-asset portfolios. However, when stock market losses are severe, correlations between assets do appear to increase, muting the benefits of correlation in a traditional portfolio. Alternative asset classes such as hedge funds may help government bonds in achieving diversification benefits.

Importantly, illiquid asset classes such as direct real estate and private equity were excluded from the analysis. This is because their returns are generally quarterly and based on appraisals rather than on market transactions, making a proper statistical comparison impossible.

Inflation effects

The behavior of asset class correlations in different inflation regimes also matters. Inflation serves as both a barometer of economic health and a catalyst for market dynamics. In particular, we analyzed economic environments characterized by extreme inflation, since ordinary correlation patterns between asset classes are generally expected to break down.

As a proxy for inflation, we used the year-over-year changes of the United States Consumer Price Index for Urban Consumers (without seasonal adjustment and available as a monthly time series). Once again, we segment the data into quantiles.

On the left-hand side, we display the average monthly return of each asset class with its average quadratic error (one standard deviation of the mean). On average, independent of the inflation environment, all asset classes but commodities deliver a positive risk premium over cash.

On the right-hand side, the beta vs. US equities is positive and quite large for most risky assets. Cash and US government bonds represent the exception. Government bonds in foreign currencies display a small, yet slightly positive correlation to US equities, most probably coming from foreign currency risk exposures and global inflation cycles.

Next, we analyze asset class returns in the quantile corresponding to the 10% highest inflation environments – i.e., year-over-year changes of US Urban Consumers CPI higher than 4.13%. In such situations, the picture changes quite dramatically.

Does volatility matter?

Next, we analyze asset class returns in the quantile corresponding to the 10% highest inflation environments, that means year over year changes of US Urban Consumers CPI higher than 4.13%. In such situations, the picture changes quite dramatically.

The chart on the left-hand side shows average monthly returns becoming strongly negative for equity indexes. Riskier fixed income assets – such as US credit, US high yield and emerging market hard currency bonds – also show negative average monthly returns. Even ‘safe-haven’ assets, such as US government bonds, provide only a limited degree of diversification as they often have negative returns.

Asset class betas to US equities are again positive and quite large for most risky assets. Interestingly, defensive government bond assets become positive. Therefore, based on the assumption that government bonds should provide diversification to riskier asset classes, traditional multi-asset solutions will most probably encounter performance problems in high inflation environments.All is not lost, however: Figure 5 clearly shows that cash and alternative asset classes might provide diversification benefits. Average monthly returns are positive for cash, commodities, and two of the hedge fund styles designed to act as ’crisis hedge’ providers.

More specifically, commodities do seem to provide some hedge against inflation, whereas their beta vs. US equities decreases. However, the variability of average monthly return is the highest among all asset classes; the hedge therefore may not be as reliable and the effects on portfolio volatility may not be ideal.

The equity market neutral hedge fund style groups long/short portfolios with little market exposure, aiming to generate return mainly by taking idiosyncratic risk (as explained earlier). The second hedge fund style with diversification potential is the macro style, which groups strategies taking long or short positions in different equity, fixed income, currency and commodity markets, mainly with derivative securities, trying to profit from the economic and political outlook for different regions and countries. These strategies appear to provide good diversification.

The findings already discussed for the 10% highest inflation environment hold true for the 5% and the 2.5% equivalents.

Volatility effects

Another variable which influences asset class correlations is implied volatility, the volatility used in option pricing models, such as the Black-Scholes model. Figure 10 shows the historical distribution of VIX levels. We can see that the VIX level distribution is skewed to the right, with historical median at 18.33, and average at 20.06.

We look at the behavior of asset class correlations in different implied volatility regimes, keeping in mind the results earlier. First, we analyze asset class returns in the quantile corresponding to the 10% highest US equity implied volatility levels.

The diversification properties of government bonds continue to hold in high volatility regimes. Conversely, when volatility increases the betas to US equities of most asset classes increase significantly. The exceptions are cash, US government bonds, foreign government bonds and the macro hedge fund style.

Equity market neutral hedge funds appear to suffer in high volatility regimes, with a sharply increasing beta to US equities. This might happen because certain types of equity market neutral strategies, such as statistical arbitrage strategies, aim to identify pairs of correlated stocks and take opposing positions based on their historical relationship – and in high implied-volatility regimes such relationships tend to break.

When we analyzed asset class returns in the 5% and 2.5% quantiles the findings already discussed for the 10% highest inflation environment were mostly confirmed. However, when implied volatility levels become extreme, even the macro hedge fund style stops providing protection. The only ‘safe havens’ in this situation are cash and government bonds.

The future of diversification

Past performance is no guarantee of future results, yet past performance is all we can analyze, and it would be illogical not to. Both inflation and implied volatility clearly influence the behavior of asset class correlations, especially during extreme market conditions. Our observations indicate that in environments characterized by high inflation and elevated volatility, diversification – the primary rationale behind multi-asset strategies – is not constant.

‘Safe’ assets such as government bonds and low-beta hedge funds appear to provide diversification against fluctuations in risk assets. However, the extent of this diversification varies.

We can now ask which types of market stress we can expect in 2025 and beyond. Inflation appears to be retreating around the world, so we do not think this will be a likely trigger of volatility (at least in the short term). However, geopolitical tensions in Eastern Europe and the Middle East are a serious concern and so (from an investment point of view) is the high valuation of US mega-caps.

In the past when geopolitical events – such as the tragic 11 September 2001 events occurred – all risk assets such as stocks and high-yield bonds suffered, while ‘safe-haven’ assets such as government bonds outperformed. Even though the September 11 events had roots in the Middle East, commodity prices did not move very much. Meanwhile, in 2022 when Russian invaded Ukraine, risk assets suffered and ‘safe’ assets outperformed, but commodities had the highest gain due to supply concerns.

In terms of US stock valuations, the dot.com bubble (during a period of low inflation) illustrated the effects of a sudden fall from high stock valuations (note we are not suggesting that the current valuations of the largest US stocks is necessarily a bubble). In 2000-2002, after the market turned away from technology stocks, while risk assets lost en masse, traditional ‘safe’ assets such as government bonds performed quite well, providing good diversification.

Therefore, if investors are concerned about geopolitics and the possible overvaluation of stocks, they should consider a diversified allocation to ‘safe’ assets, starting with liquid (such as government bonds) and possibly extending to private assets. For those that fear an explosion in commodity prices due to geopolitics, a commodity exposure may be helpful, with a focus on energy.

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Risk Warnings and Disclaimers

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Warren Takunda

Economic

British inflation jumped by more than expected to go back above the Bank of England's 2% target last month and measures of underlying price growth gathered speed too, showing why the BoE is moving cautiously on interest rate cuts.

Consumer prices rose by an annual 2.3% in October, pushed up in large part by an increase in regulated domestic energy tariffs, after a 1.7% increase in September which was the first time the inflation rate had fallen below the BoE's target since 2021.

Sterling was up by almost a third of a cent against the U.S. dollar immediately after the data was published and interest rate futures priced in a slightly slower pace of rate cuts.

The BoE's most recent forecast and a Reuters poll of economists had both pointed to a CPI reading of 2.2% in October.

"These figures confirm a disappointing resurgence in inflation as the recent tailwind from lower energy costs turned into a headwind in October, following the increase in (regulator) Ofgem's price cap which drove a notable jump in household bills," Suren Thiru, Economics Director at accountancy body ICAEW, said.

The increase represented the biggest month-to-month rise in the annual CPI rate since October 2022.

Services inflation - which the BoE views as a key measure of domestically generated price pressure - rose to 5.0% in October from 4.9% in September, the Office for National Statistics said.

The BoE had expected it to rise to 5.0% in October.

Core inflation, which excludes energy, food, alcohol and tobacco, picked up to 3.3% from 3.2% in September.

"While the slight uptick in services price pressures confirms that it remains a significant hurdle to sustainably maintain inflation below target, slowing wage growth and a weakening labour market should help put it on a more consistent downward trajectory," Thiru said.

Chief Secretary to the Treasury Darren Jones said the government was trying to help reduce the cost of living "but we know there is more to do." Science minister Peter Kyle told Times Radio: "This does concern us."

BoE Governor Andrew Bailey on Tuesday stressed the central bank's message that borrowing costs are likely to come down only gradually as policymakers were awaiting clearer signs of how much inflation pressure remains in Britain's economy.

Earlier this month, the central bank said the first budget of Britain's new government was likely to add to inflation next year and beyond as higher taxes on companies were likely to translate into higher prices.

Source: Reuters

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