Toothpaste and Correlation
We mentioned in Snapshots in January that synthetic CDO market volumes are increasing again. We recently looked at the implied correlation risk in equity index tranches which is still at elevated levels post the financial crisis.
Correlation across tranches has often been described as toothpaste in a tube that gets pushed around the tube. Currently this toothpaste is in the equity tranche.
If idiosyncratic risk is increasing as we move to a normalised world without heavy central bank intervention, you could argue that correlation could fall from these high levels. This would cause equity tranches to suffer MTM losses which is what happened during the Ford and GM automotive crisis in 2005.
Conversely, the reason for high equity correlation levels could be that the market is still pricing in high systemic risk because it has not adjusted to the new monetary dynamic. This is something we are still debating.
Toothpaste and Inflation
The other toothpaste analogy comes from former Bundesbank president, Karl Otto Puhl: “Inflation is like toothpaste. Once it’s out you can hardly get it back in”.
Although inflation is slowly increasing, it is still surprisingly well behaved given low unemployment and low spare capacity in the global economy. We continue to monitor this closely given the late cycle fiscal stimulus in the US and the political move to less austerity and more fiscal stimulus in Europe.
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