There are fundamental links underlying the market that wax and wane depending on what the prevailing concerns are among investors. For example, one of the most prevalent trends of the past 18 months has been the health and direction of underlying risk appetite. With the 2009 rebound in speculative interests, the market would ultimately rank each currency by its potential for return. The greater the divergence in yields, the more attractive the pair was with traders hungry for return.
The following is our monthly correlations update for January. 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 each other (and in conjunction to other markets). There are a few reasons why this is significant, but most importantly, it allows traders to understand their net exposure. Such exposure goes beyond merely buying or selling too much of a single currency against its various counterparts.
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The greater the divergence in yields, the more attractive the pair was with traders hungry for return. However, since global interest rates were lowered to near zero, it was difficult to easily classify certain pairs, and other fundamental factors came into play. An example of this phenomenon can be found in the correlation between USD/CAD and AUD/USD with contrast to the relationship between USD/CAD and USD/JPY.
The USD/CAD currency pair is not easily classified from a risk perspective due to roughly equivalent interest rates and a tight economic link between the two economies. However, traders would nonetheless work to classify the greenback as the funding currency and the loonie as the carry currency through the relatively mild recession in Canada and its traditional relationship to commodities. In turn, the correlation between USD/CAD and AUD/USD has held relatively high over the past six months (-0.71– negative because the base currency is flipped between the pairs).
USD/JPY is another unusual pair. The US dollar has recently drawn attention as a funding currency for lowering its benchmark market rate (the three-month Libor) to a record low, below its Japanese counterpart. On the other hand, the long-term prospect for a stable funding currency no doubt goes to the Japanese currency. This has led the pair to flounder when risk trends are on the move and mark steep trends when the rest of the market is unmoved. This has consequently led USD/JPY to track a course almost entirely independent of USD/CAD (-0.03) and the rest of the majors over the past six months.
And, yet, these trends’ relationships will no doubt change with time. Evidence of frequent changes in the role of carry currency with USD/JPY can be seen in the one-month trailing correlation with EUR/USD (a consummate follower of risk trends). This past month, the correlation between the two was -0.42, and in November, it stood at 0.02. Most correlations change with time, but this particular pair is unique for its stance in a major fundamental trend.
Regardless of your trading strategy and 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.
By John Kicklighter, currency strategist, DailyFX.com
