Correlations Intensify as Risk Appetite Blurs

Forex Correlations (December): How Do Currencies Trade In Relation To Each Other?

The following is our monthly correlations update for December.  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 twelve-month correlations for the seven major currency pairs.  Additionally, we have included the six-month trailing correlation for the majors against the EURUSD 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 well beyond merely buying or selling too much of a single currency against its various counterparts. There are fundamental links underlying the market which wax and wane depending on what the prevailing concern in the market happens to be. For example, through the past month; we can see evidence that the influence of various fundamental drivers is being refined down to a couple prominent, underlying themes. One of those key concerns rests with the dollar’s influence on the market. The greenback is the world’s most liquid currency and is therefore tapped into broader considerations like risk appetite and the global outlook for growth. To highlight the streamline fundamental backdrop, we can look to the correlations the EURUSD holds against AUDUSD and USDCHF. It is not unusual to see a strong negative relationship between the euro and franc-based majors; but November’s figure (-0.99) is no less impressive. Months ago, both the dollar and franc were considered safe haven currencies when fear was rousing volatility. However as the aggressive rebound in the markets matures and the franc loses appeal as a harbor in stormy markets, the focus was brought back to the economic link between the Euro Zone and Switzerland; and comparing their collective outlook to that of the United States. At the same time, we have also seen risk appetite cool in the past month. This has in turn focused the relationship that sentiment creates. Both EURUSD and AUDUSD (0.80) are the ideal benefactors to the dollar’s weakness and primary losers when in strengthens. The euro is the primary counterpart to the dollar through liquidity and fundamental background; but Australia is considered the best-performing, major industrialized economy. When fear rises, the demand for a safe haven naturally boosts the dollar in EURUSD and reverses a clear yield play in AUDUSD.

However, both the focus on risk appetite and the position of the Swiss franc in the currency market are ever evolving. We can see point to changing correlations over time that highlight both. Offering a look into both factors at once, we can compare USDCHF and NZDUSD over the past month and entire year. Through the year, the relationship was much more tame (-0.49) as the franc’s position as a safe haven competed with the US dollar. However, in the past month, as the dollar has been slowly forced to the bottom of the spectrum and investors have had to look more closely to find yield as capital advances were stalled, this same relationship has tightened (-0.73). For this reason, having this knowledge will allow traders to effectively diversify and manage their portfolios over time.

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.