* Traditional asset correlations disrupted

* Currency and inflation relationships have broken down

* Gold not acting as a buffer, moving unusually with

equities

By Amanda Cooper

LONDON, April 24 (Reuters) - The traditional global

asset correlations that collapsed when the war in the Middle

East erupted remain broken, leaving investors to piece together

strategies to trade the road to resolution with a faulty

instrument panel.

Record highs for Wall Street stocks belie concerns

about fraught geopolitics, how long energy supplies might be

disrupted for and long-term economic damage.

BMO chief FX strategist Mark McCormick reckons the next

three to six months will not resemble the "pre-conflict normal".

"The growth factor is recovering, but remains below

late-2025 levels, the rates (monetary policy) factor remains

elevated, correlations are shifting, and drawdown risk is

rising. Something new is forming," he said in a note.

Here's a look at the disruption to classic correlations in

stocks, bonds, currencies and commodities that have

traditionally provided a steer on economic trends.

A HARD TEST FOR FIXED INCOME

Stocks and bond yields usually move together, as investors

tend to hedge economic growth worries, which hit stocks, by

buying bonds, sending yields lower and vice versa.

That relationship has been more erratic since the pandemic, as

higher inflation and government debt undermine the ability of

bonds to act as a hedge against equity risk.

The International Monetary Fund, in a pre-war blog in February,

warned that investors and policymakers must rethink risk

management for "a new era" where traditional hedges fail.

Two-year bonds, sensitive to inflation and interest rate

expectations, have been in the eye of the storm.

The one-month rolling correlation between two-year Treasury

yields and the S&P 500 has collapsed to around

-0.8 from an average of 0.23 over the last five years. Since the

war started, that metric is at -0.63. A near-identical pattern

emerges for two-year German yields and European

stocks.

"There definitely wasn't a move into sovereign fixed income

in March, which, at least at the front end, you might have

expected," said State Street head of macro strategy Michael

Metcalfe.

"This was a hard test for fixed income, because it was an

inflation shock and also potentially a growth shock, which

doesn't help the long-term fiscal concerns."

GOLD IS MISBEHAVING

Gold has ditched its safe-haven credentials since the

war began, moving unusually closely with equities and even

volatile crypto. It remains 10% below pre-war levels.

Gold usually boasts a robustly negative correlation to the

dollar. When volatility picks up to the point where investors

ditch stocks, bonds and other markets, the dollar emerges as the

main beneficiary, as has been the case during the war.

Since late February, the correlation between gold and the

dollar has softened to around -0.19 from an average of -0.4,

while the correlation between gold and stocks has been around

0.55, up from a five-year average of 0.22.

This probably speaks more to the correlation of the dollar

to stocks, which has hit a record -0.94 this week, indicating an

almost-perfect inverse relationship, versus a five-year average

of -0.28.

Meanwhile, the bitcoin/stocks correlation is at a record

0.96, from an average of 0.4 pre-war, denting the case for

crypto as a diversifier.

"EXTRAORDINARY EVENTS HAVE UNUSUAL EFFECTS"

The prospect of an inflation shock has prompted traders to

price in rate hikes, particularly in Europe, and to lower

expectations of rate cuts in the United States.

Higher rates in one region than another usually imply

strength for one currency over another, but even this

relationship has broken down.

The European Central Bank is expected to hike rates twice

this year, while the Federal Reserve leans towards a cut. Yet

the euro, at around $1.17, has barely recovered its

war-driven losses.

"Extraordinary events can have unusual effects on financial

markets, often altering traditional relationships between

financial variables," UniCredit said, adding that the

relationship between euro/dollar and rate differentials is one

of those casualties.

Using the difference between two-year U.S. and euro zone

swap rates, the correlation between rate differentials and the

euro itself is at 0.5, up from near 0 at the start of the year

and compared with an average of -0.3 in the last two years.

"We do not think that rate differentials are likely to

return to being the key driver for euro/dollar until the

war-driven risk premium has dissipated," UniCredit added.

DIVORCED FROM FUNDAMENTALS

Rising oil prices would normally lift inflation

expectations, but these have fallen since the war started.

The five-year-five-year forward U.S. inflation swap, a gauge of

investors' long-term inflation expectations, is around 2.4%,

from closer to 2.45%. Oil prices are still around 40% higher.

The correlation between the two is around -0.7, above the

five-year average of 0.2. During the 2022 energy shock, it hit a

high of 0.7 following Russia's invasion of Ukraine.

Deutsche Bank says this switch could be partly down to an

expected increase in U.S. fiscal deficits as Washington funds

the war.

"But another possibility is that forward inflation

compensation has become increasingly divorced from

fundamentals," the bank said.