How Currencies Correlate to Each Other

05/06/2009 12:01 am EST

Focus: FOREX

The following is a monthly correlations update for May.  As we have stated time and again, correlations between different currency pairs will inevitably shift over time. Therefore, it is of utmost importance to keep abreast of these fluctuating relationships to fully understand your trades and portfolio.  Below are the one-, three-, six-, and 12-month correlations for the seven major currency pairs.  Additionally, we have included the six-month trailing correlation for the majors against the EUR/USD for a different view of correlation.

In order to be an effective trader, it is important to understand how different currency pairs move in relation to one another.  There are a few reasons why this is significant, but most importantly, it allows traders to understand their exposure.  For example, having a portfolio that consists of the AUD/USD and NZD/USD is different than having a portfolio comprised of AUD/USD and USD/CAD.  In the past five months, the markets have found what passes as an extended period of stability.

While this is not necessarily the definitive sign of a recovery, it has led the deleveraging flows of the past two years to slow and encouraged reinvestment in yield-bearing investments. In turn, we have seen the correlation between the high rate differentials from AUD/USD and NZD/USD cultivate a high, positive correlation (0.89) as traders moved out of the safe haven US dollar and into the deeply depressed commodity currencies. Similar fundamentals are behind the AUD/USD and USD/CAD’s strong, negative relationship (-0.86) over the past month, but here we see the commodity factor coming more into play.

From a trading perspective, this means that having long exposure in both AUD/USD and USD/CAD would generally negate profit or loss because when AUD/USD rallies, USD/CAD will sell off the majority of the time.  Of course, these two currencies may have different pip values and the correlation is not perfect, so the P/L will not be exactly zero. In contrast, holding long AUD/USD and NZD/USD positions would be akin to nearly doubling up in one of the pairs since the correlation is so strong. 

Furthermore, we can tell from our tables that correlations rise and fall through different periods.  Over the past six months, the correlation between USD/JPY and GBP/USD was relatively strong (0.53). This is largely due to the shift that the influence of risk appetite has had on the general market. Both the US dollar and Japanese yen are considered safe haven currencies.

Therefore, when there is no extreme in sentiment, USD/JPY is left to chop, while GBP/USD continues to play out its far more sensitive relationship to the back and forth in optimism. Over the past month, however, the relationship has recovered (0.53) as the slow recovery in risk appetite has led to an appreciation in those currencies considered to be income currencies.  Overall, having this knowledge will allow traders to effectively diversify and manage their portfolios.

Regardless of your trading strategy or whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to keep in mind the correlation between various currency pairs and their shifting trends.

FX Correlations (Data as of 05/01/09)

By John Kicklighter, Currency Strategist, DailyFX.com

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