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The market cares more about a friendly Fed than the Brexit vote

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The US stock market has not made any new highs in more than a year. Because during the previous six years it went up 150% virtually without interruption, some fear that the market’s inability to break new records could mean that the rally is finally over.

To be sure, the rally has been met with this kind of distrust since the beginning. Its imminent end has been predicted many times, but it marched on for six years to the dismay of many observers who wanted to be first at calling the top.

There is no question that one day the market will stop going up. If history is any guide, it will come a time when it will slump and move sideways for a while, perhaps years. The trick, of course, is that nobody knows when that will happen, nor it seems likely that anyone will be able to identify the beginning of such phase even after it started.

One indicator that has raised red flags is the VIX, or “fear index.” This is a measure of the expected, or implied, volatility of the S&P 500 in the months to come, and it is always associated with a market decline because it reflects the price of insurance (through options) against a market fall. The stronger the demand for insurance, the higher the VIX.

The VIX has gone up sharply in the last few trading sessions, climbing to its highest level since February. While some of this is due to market weakness, the VIX surged far more than during similar recent market declines. To some, this is a sign that something might be brewing.

One does not have to look far for possible dangers. The most obvious could materialize on June 23, when the UK will have a referendum on whether to exit the European Union (“Brexit”). All observers agree that it could be quite disruptive to risk assets, at least temporarily, if voters choose to leave.

But this is not the only source of concern. Negative interest rates, not long ago considered impossible, are now entrenched in many developed markets. In addition, the pace of bankruptcies larger than $1bn is at its liveliest since 2009; closures at major retail chains now surpass any level since 2010; junk bond defaults are rising and expected to go up; the outcome of the US presidential election could prove quite unfriendly to markets, and so on.

While there may be many reasons for market participants to seek insurance against a market slump (and push up the VIX), another powerful indicator points in a different direction.

The correlation among assets and sectors has been falling, and this is usually a sign that investors are becoming less concerned about the chances of a market crash.

While the VIX, or implied volatility, is informative about investor mood, the correlation among assets – i.e. the extent to which they move together – is a key gauge of investor confidence: optimism leads to lower correlations, pessimism to higher correlations. This is because when market expectations take a hit, investors tend to sell their positions indiscriminately, pushing asset prices down in unison, thus increasing the correlation among them. Conversely, when investors are confident about market prospects, they engage in the minutiae of relative value, buying some assets and selling others. This drives correlations down.

Where are correlations now? While the higher VIX means that future volatility is expected to go higher, the fact is that actual volatility has decreased in the last couple of weeks, and correlations have fallen. This suggests that there is little evidence that pressure leading to widespread selling could be building behind the scenes. US equity sectors seem particularly well situated with respect to the last nine months, as both the correlation among equity sectors and the overall volatility of a hypothetical US-equity sector portfolio including small cap stocks are at their lowest point. A similar portfolio of global risk assets that includes emerging and non-US developed market stocks and commodities is in a somewhat less privileged state, but far from a “danger zone.”

Market volatility and correlation at healthy levels

So while the cost of insuring a portfolio of US stocks has gone up, correlations do not point to a deterioration of market conditions. While this change in a flash, there is no evidence that market sentiment is currently souring.

A simple explanation to this might be that the VIX is going up simply because the market is seeking insurance in advance of the Brexit vote, but does not actually believe that, even if it goes through, it will lead to an extended market crisis. Investors might be buying insurance but don't seem bothered enough to engage in substantial rebalancing of their portfolios.

This remarkable calmness in the face of highly unusual market conditions (like Brexit and negative rates) suggests that investors, rightly or wrongly, are quite reassured by the Fed's retreat from earlier hawkishness. If this is what is happening, it is another reminder that the co-dependence between the Fed and the markets will not end anytime soon.

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