What Does Correlation Mean for Currencies?

07/23/2009 12:01 am EST

Focus: FOREX

Boris Schlossberg

Managing Director of FX Strategy and Co-Founder of BKForex LLC, BK Asset Management

Since the start of the financial crisis in 2007, there has only been one trade across all the capital markets—risk on or risk off. As equities collapsed, the dollar and the yen gained while the euro, the pound, and the Aussie, along with oil and gold, all declined. As the recovery trade took hold, the process has reversed and all the risk currencies have marched almost lock in step with equity prices.

What has been astounding about the process is the degree of correlation involved. On a yearly time frame, the correlation between equities (represented by the S&P 500) and commodity currencies (like the Australian and Canadian dollars) has been nearly 90%. On an intraday basis, the correlation between the dollar index and equities has been a remarkable -.98 (the correlation is inverse because the dollar rallies when equities fall).

S&P 500 vs. Canadian and Australian Dollars


Click to Enlarge

Such patterns cannot last forever. As more and more market players exploit the correlation trade, it becomes too crowded and will eventually break down. Ultimately, the currency, equity, and commodity markets will begin to decouple as each starts to trade on its own fundamentals. However, for the time being, the risk trade completely dominates flows in all the key asset classes.

With the S&P having broken the key 950 level, traders will be looking at the Dow Jones 9000 level as the key psychological mark to give way to the upside. If the recovery rally can continue for a bit longer and correlation of markets remains in place, the trend points to EUR/USD 1.4500 as the next target on the risk assumption trade.

By Boris Schlossberg of GFTForex.com

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