FX Correlations (February): How Do Currencies Move In Relation To Each Other?

In order to be an effective trader, it is important to understand how different currency pairs move in relation to each other.  There are a few reasons why this is significant, but most importantly, it allows traders to understand their exposure.  For example, having a portfolio that consists of the AUDUSD and NZDUSD is different than having a portfolio comprised of AUDUSD and USDCAD.   Over the past weeks and months, a rise in risk aversion as well as substantial rate cuts among the commodity bloc has led this particular sector to track out very similar moves. For example, sharp rate cuts from both the RBA and RBNZ has lead to a high, positive correlation between AUDUSD and NZDUSD (0.90). Alternatively, representing countries that were at one point expected to largely avoid the worst of the global slump (a fundamental buoy that is now fading), the AUDUSD and USDCAD pairs have established a considerable negative correlation (-0.85).  From a trading perspective, this means that having long exposure in both AUDUSD and USDCAD would generally negate profit or loss because when AUDUSD rallies, USDCAD will sell off the majority of the time.  Of course, these two currencies may have different pip values and the correlation is not perfect, so the P/L will not be exactly zero. Alternatively, holding long AUDUSD and NZDUSD positions would be akin to nearly doubling up in one of the pairs since the correlation is so strong. 

Furthermore, we can tell from our tables that correlations depending on our time frame.  Over the past month though, shifts have been more subtle, suggesting the market is consolidating and fundamental concerns in risk and growth are more mature. One of the most notable shifts was in the relationship between USDCAD and USDCHF. Over the past six months, when risk trends were far more prevalent, we saw the attention to risk trends was forcing the market to pick its safe havens and these two pairs subsequently shared a notable 0.33 correlation. However, with time fear would settle and fundamental forecasts would eventually focus more on growth – and leading the pairs’ relationship to flip (-0.14). Shifts such as these occur often and can be partially explained by changes in the severity of monetary policy or changes in market conditions.  Overall, having this knowledge will allow traders to effectively diversify and manage their portfolios.

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 02/02/09)

Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.