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Correlations Moderate as Technical and Fundamental Trends Ease

Correlations Moderate as Technical and Fundamental Trends Ease

2010-03-08 23:54:00
John Kicklighter, Chief Currency Strategist
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Forex Correlations (March): How Do Currencies Trade In Relation To Each Other?

The following is our monthly correlations update for March. 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 monthly 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. However, it is worth noting that aside from a few standout correlations (negative and positive) amongst the majors; the relationships in price action across the majors has generally dissipated in recent weeks and months. This is an unmistakable consequence of tempered volatility and curbed risk appetite trends. Through this period of stability and merit-based positioning, traders are more selective of where they place their money and are less prone to foster strong correlations. Yet, as soon as primary trends and dominant fundamental drivers return, the trading ties will quickly return. Given the recent stability recently established in key currencies (like the US dollar, Japanese yen and euro), it may seem that this disassociation can persist indefinitely; but threats running from a Chinese asset bubble to a default within the European Union are too prevalent not to exact a forceful influence on investor attitudes one way or the other.

Looking for standout associations amongst the majors, the latent impact of risk appetite trends is still exceedingly clear across those pairs that are particularly sensitive to risk appetite trends. This is the reason that the correlations amongst the commodity bloc (USDCAD, AUDUSD, NZDUSD) are so severe. However, there those pairs that stray from the traditional high yield differential category and still exhibit an extraordinarily high level of correlation. Perhaps the strongest connection can be drawn between the price action of EURUSD and USDCHF. This is a unique situation whereby the economic and policy links between the Swiss and Euro Zone economies create a fundamental equivalency that creates something akin to an arbitrage situation when the two are mispriced. Hence the strong negative relationship between EURUSD and USDCHF price action over the past month (-0.97). Alternatively, the strong 0.81 correlation between EURUSD and NZDUSD over the past month would seem to part with conventional wisdom. However, speculation over the stability of Greece this past month has exacerbated the euro’s dependency on strong risk appetite and thereby leveraged the greenback’s appeal as a source of stability in both pairs.

Furthermore, as evidence that the influence of dominant fundamental trends like risk appetite wax and wane with time; we can point to the 1 month trailing correlation between EURUSD and USDJPY. Through February, the two showed a statistically nonexistent relationship (0.09). However, through December, the two would more frequently move in opposite directions (with a correlation quotient of -0.42) as the market would seek liquidity rather than simply act to repatriate carry funds (which find capital flowing to the Japanese yen as surely as to the US dollar).

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 03/01/09)

CORR308a

CORR308b

Written by: John Kicklighter, Currency Strategist for DailyFX.com
E-mail: jkicklighter@dailyfx.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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