Forex Correlations Shifting Over Past 18 Months

04/07/2010 12:01 am EST

Focus: FOREX

Correlations between currencies are not arbitrarily developed. They are often born from fundamental commonalities between various pairs, shared traits whose importance can wax or wane with time. One of the most prominent and consistent “themes” of the past 18 months has been the intensity of risk appetite trends. This does not necessarily refer to a direction in sentiment, but rather its overarching influence over valuation and price action.

Below you’ll find our monthly correlations update for April. 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 monthly 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.

When fear or greed moves to one or the other extreme of the normal spectrum, the most other “mundane” factors can be overlooked. This has been the case for the currency market through the height of the crisis through the end of 2008, and the strong, subsequent rebound in the risk for return throughout 2009. Through this period, the correlation of risk appetite has been one of the most palpable. However, eventually, momentum behind risk appetite swings will moderate, leading investors and traders to be more critical of the positions they build or unwind. In turn, the different currency pairs and asset classes that have seen such impressively linked moves will begin to diverge. We are already beginning to see this happen with some of the favored risk-based pairs.

Over the past few years, there has been a general consensus that the US dollar, Japanese yen, and Swiss franc were the top-three funding/safe-haven currencies. However, since rates were lowered globally, the corner has been turned on an economic recovery, and monetary and fiscal policy has taken different paths with different economies, we have seen the lower echelons of risk growing apart. Perhaps the most remarkable divergence has developed between USD/CHF and USD/JPY. Eighteen months ago, both the franc and yen were enjoying the inflows related to carry unwinding and a moderate flight to safety. However, these flows (both a move towards risk aversion and return) have cooled, leaving the one-month correlation between the two majors at a moderate 0.43. In the background, though the US dollar’s benchmark yield is at a record low, its market rate has started to climb higher, while other region’s are falling behind the expected rate curve. Another issue is that the Swiss franc is itself losing some of its appeal as an international safe haven with slackened banking regulation. This has increased the country’s dependency on the health of the euro zone and thereby maintained the correlation between EUR/USD and USD/CHF (with a 0.94 score through March). Expect these domineering relationships to continue to dissipate until the next clear and market-spanning trend develops.

Taking another approach to the fundamental correlations within the markets, there have been significant month-over-month changes between static pairs.

For example, the connection between EUR/USD and NZD/USD has changed dramatically between March and February. Two months ago, the two would move frequently in the same direction from day to day (with a reading of 0.83). Yet, just this past month, that hand-in-hand pace was significantly diminished (0.46) when concern over a Greek default moved beyond the phase whereby the masses expect a financial crisis to the point where they recognize the more lasting, negative impact such an outcome would have on the euro zone and its economy.

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.

FX Correlations (Data as of 04/01/10)


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By John Kicklighter of DailyFX.com

DailyFX provides forex news on the economic reports and political events that influence the currency market

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