With markets showing signs of high correlation, which was also a feature of the 2008 financial crisis, the FT's Dan McCrum explains why these movements point to turbulence underneath the tranquility of markets.
Produced by Filip Fortuna. Filmed by Rod Fitzgerald and Bianca Wakeman.
Helped by insight from the skulls of upper caste Indians comes a financial theory which might feed the nerves of those who worry markets too quiet. Stock markets, bond markets, and currency markets have all entered states of tranquillity with little day to day movement. But the way asset price movements are interacting, well, that displays a high level of what statisticians might call on "unusualness."
The idea is related to correlation-- the extent to which movements of the price of one thing are related to another. On a normal day, changes in the price of a barrel of oil delivered to a refinery in West Texas might be expected to show little relationship to, say, the share price of an online social media company. So if the two start to move together, becoming highly correlated, it might be considered unusual.
A feature of the financial crisis was large markets around the world plunging and then rebounding in unison. The reverse would also be the case. If bond prices for two Austrian banks suddenly stopped moving in similar ways, that, too, would count as unusual. Measuring and assessing all of these correlations against great swathes of assets, well, that becomes a practical problem.
In 2010, however, a pair of academics considering market turbulence borrowed a technique developed by a 20th century anthropologist to assess scull measurements of Anglo-Indians in Calcutta-- the Mahalanobis distance. Their work produced a measure of unusualness of asset price movements over time. Three years later, a paper from State Street Global Investors attempted to separate two aspects of such turbulence.
The size of price movements from what was called "correlation surprises," the unusualness of price movements on a given day compared to history. Now at the moment, the level of correlations of prices is high, which gives some reason to worry trouble may be brewing beneath the tranquil surface of markets. Now of course, small price movements like we see at the moment tend to offer less information than more violent markets.
But if things start to change, well, the combination with surprising correlations and violent markets-- that tends to produce the most persistent bouts of painful turbulence. So watch out. And it is fair to say, we live in times of unusualness.