Given risk-on and risk-off mood swings, the best forex barometer may be the euro as the stops at 1.1...
Safe Currency Pair: an Oxymoron?
10/05/2012 6:00 am EST
John Forman, author, The Essentials of Trading, emphasizes the importance of understanding the correlation between foreign currencies before trading.
I usually think the stuff put out by OANDA is pretty solid, but a post on their blog Tuesday definitely fell short of that standard. Using their correlation matrix—which I do think is very useful and which I posted about on Facebook and Twitter not long ago—the author looked to make the case that USD/CHF is the best safe haven currency pair.
First of all, currency pairs are not safe havens. That only works with individual currencies. At various points in recent years the USD, the CHF, and even the JPY have been tagged as safe haven currencies. This is an indication of where global capital is likely to move during times of stress. The result is that when the markets are risk-off, money will flow from risk currencies (currently the likes of the EUR and AUD) into safe haven currencies, and that will reverse with the markets go risk-on. This tends to make the pairs which join up safe haven and risk currencies (AUD/USD, for example) particularly volatile in times of shifting market psychology.
Shifting to the OANDA blog author’s argument, though, we get into the area of correlation. The point made is that USD/CHF is almost perfectly negatively correlated to EUR/USD in nearly all time frames. Let’s think about what those causes are:
1) The USD positions in the two pairs are opposing
Any two currency pairs which have the USD in them are going to be fairly strongly correlated most of the time. Whether that is negative or positive depends on whether the USD is in opposing positions in the pairs (base in one, quote in the other) or in the same position (base in both or quote in both). In the case of EUR/USD and USD/CHF we have the dollar as quote currency in one and base currency in the other, so we have a natural negative correlation.
2) The EUR and CHF tend to be influenced by common factors
This means both the euro and franc have a long history of seeing their values rise or fall on the basis of the same news and fundamental information. As a result, they tend to move in the same direction most of the time, though the amplitudes of the moves do vary (which is the cause for movement in EUR/CHF). Because EUR/USD and USD/CHF have the two currencies in opposing positions (as noted with the dollar above), there is a natural negative correlation between the pairs.
3) The Swiss National Bank has put a floor under EUR/CHF at 1.20
Because of the persistent issues in the Eurozone and the perception of the franc as a safe haven (meaning flows out of the EUR and into the CHF), this has effectively meant that EUR/CHF has been pegged at or near 1.20 for long periods of time of late. That means the euro and franc have traded in near lockstep. Going back to the relationship between EUR/USD and USD/CHF noted in 2) above, this is the strongest case of all for a very strongly negative (near -1) correlation between the two pairs.
Put all this together and you get the reason for USD/CHF trading at a near perfect negative correlation to EUR/USD being that the EUR and CHF are virtually the same currency these days, and both pairs feature the same opposing currency (USD) on the other side. Of course they are going to be strongly negatively correlated!
Because of the strong negative correlation between EUR/USD and USD/CHF, hedgers may look at the two as presenting an opportunity. I would note, however, that being long EUR/USD (for example) and hedging with a long USD/CHF position would only serve in creating a synthetic (and overly expensive) EUR/CHF long position.
The bottom line with the correlation stuff, which seems to get everyone very excited these days for some reason, is that it’s important to know why two markets are correlated (or uncorrelated). If you don’t, then you may find yourself in a nasty position where the correlation breaks down and catches you out because you weren’t prepared for it based on an understanding of the market dynamics at work.
And getting back to the idea of USD/CHF being the best safe haven currency pair…I’m sorry, but just looking at the correlation to EUR/USD alone is a far cry from sufficient evidence to make such a claim. You’d have to do a full analysis to see which pair or pairs is most reactive to safe haven capital flows before making any claims. Correlation analysis doesn’t get you there.
By John Forman, Author, The Essentials of Trading
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