special reports

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

Friday, 02 January 2009 15:39:29 GMT  |  John Kicklighter, Currency Strategist

The following is our monthly correlations update for January.  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.  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.   As can be seen in the tables below, the congestion in risk appetite has had a unifying influence for the high-yeilding AUDUSD and NZDUSD pairs – whose one-month correlation now stands at (0.90). Finding common ground in relative economic strength and a contrasting background for rate activity, the AUDUSD and USDCAD pairs have derived a considerable negative correlation (-0.81).  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 shift with time.  In the past month, broad risk aversion trends were sidelined by a drop off in liquidity. This certainly contrasted the panic-like state seen through October when deleveraging and carry trade unwinding saw a broad rally in dollars and Japanese yen. Evidence in the shifting state of the market can be seen in the correlation between USDJPY and AUDUSD through December compared to its relationship over the previous three months. Through the final quarter, the two had a relatively strong correlation (0.62) reflective of the mass buying of yen and dollars as a safe haven. In contrast, when this market force abated through December, the relationship flipped (-0.28) as dollars came under pressure. 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 01/02/09)

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