Currency Correlations Tighten Through Risk and Dollar-Based Foundations

Currency Correlations Tighten Through Risk and Dollar-Based Foundations

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

The markets are varied and extraordinarily nuanced between different assets and currencies; but there are underlying trends and fundamental drivers that can account for much of the market’s price action. One of the most recognizable currents amongst the FX crowd is the influence that risk appetite trends have on various currencies and pairs. Something of a derivative to this common theme, but also something of a unique driver unto itself, is the influence that the US dollar has across the broader market. It may seem logical that all those pairs that have the greenback as a root currency will react to changes in fundamentals or speculative positioning that are sourced from or catalyzed within the US markets. Yet, many do not recognize the flow of capital in or out of the world’s largest economy and market can have a sweeping impact on the other liquid currencies. This does not even have to be a consequence of risk trends – though the need for a safe haven or appetite for risk is often amplified by the single currency.

To observe the influence that the US dollar has on the currency market in general, we can highlight those crosses that aren’t dependent on risk trends or are more reasonably based on economic or capital flow-based fundamentals. Without doubt, the best measure for the dollar’s strength (or lack thereof) is EURUSD. If we were to set that pair’s day to day activity over the past month against another fundamentally rooted currency like GBPUSD (with a relationship of 0.93), we can see that there is a commonality that isn’t solely based upon the greenback’s status as an alternative to all that is risky. However, there is evidence that sentiment still conforms to the same dollar-based picture. Looking at the association between EURUSD price action and that of AUDUSD (one of the most stable yield differentials amongst the majors) we see that the relationship is still very strong (0.84).

Recently, the momentum/conviction behind risk appetite trends has cooled significantly as investors await a clear outlook for economic activity and the future of returns. The best measure of risk appetite itself happens to also be correlations – between specific currencies and other asset classes as well. When there is a strong and steady trend for those securities that benefit when risk is climbing (high-yield currencies, equities, commodities, etc) as well as the inverse trend when safe haven and liquid assets come into demand (the US dollar, Treasuries, money market, CDs, etc), the level of connection between the otherwise distinct assets tell us that capital is seeking the same thing. However, when sentiment is little moved and aimless, it is common for relationships to break down. Looking back over the past seven months, we have the conviction behind risk demand wax and wane. In fact, if we look back through the month of May when most risk-based assets started to level off, the level of coordination between EURUSD and AUDUSD had dropped to near insignificant levels (0.38). However, with demand for yield pushing up high yield currencies (along with equities and other return-heavy assets) through the month of July, the relationship between the two tighten significantly (0.84).

Keeping track of what side of the market different currencies and assets fall along with intensity of trends and level of correlations can give a remarkably complete reflection of the markets. And, it should be said that under some circumstances offer a clearer picture of the fundamental backdrop than economic data can. Since the market is a collective of investors absorbing and reacting to data, there is some level of discretion as to what is important and what is not when trading. Monitoring price action and correlation reveals what the market as a whole thinks is important rather than subjectively impressing one’s own biases onto an entity that has no interest in any individual’s positioning.

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 07/01/10)