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Currency Correlations Show Risk Appetite Trends Yielding to Fundamental Concerns

Currency Correlations Show Risk Appetite Trends Yielding to Fundamental Concerns

2010-07-07 20:55:00
John Kicklighter, Chief Currency Strategist
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The following is our monthly correlations update for July. 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.

For the past two years, one of the most common fundamental themes behind the FX market (all capital markets for that matter) is the ebb and flow of investor sentiment. Initially, it was the wholesale withdrawal of speculative capital from the market that would coordinate the movement of all securities and currency pairs that had a clear dependence on yield. Then, from the first half of 2009, with yields and expected returns at extremely depressed levels, the broad reinvestment into the market after the dust cleared would send the same speculative assets into a recovery rally that put traders onto capital returns. These two clear trends were the product of broad market flows that tightened correlations to remarkable levels. However, since the start of the year, it has become more and more clear that the global economy has turned towards recovery and financial stability has tightened significantly. This general assessment helps to curb risk trends and breaks up the correlations based upon that drive. What is left is a market that is far more critical of fundamental health and yield potential amongst specific currencies.

One of the more interesting deviations from the common risk theme this past month is from the dollar itself. Against high-yield currencies, the greenback is still a consistent safe haven currency; but we have seen this role diminished in recent weeks for EURUSD and it has certainly dissipated for more questionable risk-based pairs like USDCHF. A remarkable slip in correlation comes through one-month correlation between EURUSD and USDCHF through June (-0.60). Just a few months ago, this period reading was far greater (above -90) and we can even see over a longer period that the relationship has been far greater (-0.86 over the past year). Part of this can be attributed to the Euro’s own troubles – what may be the next financial crisis – that has lead EURUSD to keep its distance from traditional risk-based pairs like AUDUSD (0.71). At the same time, the risks associated with the US dollar’s financial forecast has increased its perceived dependence on investor sentiment when compared to the traditional funding currency – the yen. In this relationship, we can use the correlation between the USDJPY and AUDUSD over the past month (0.55) and three months (0.64).

Looking at the ever evolving financial instability behind the euro and the diminished safe haven status of the greenback (mixed with the blurred outlook for risk trends themselves), we can see significant changes in monthly correlation readings from month to month. Going back to the EURUSD and AUDUSD correlation from June (0.72) we can draw a stark comparison to what it was just the month before (0.36). Through this period, there was a significant shift in risk appetite considerations while the focus would turn on the euro for its link to the next potential financial crisis. The risk inherent in the shared currency clearly gave it the feeling of a “risky” or “high yield” currency. Watching these month to month shifts is now important than looking at the absolute links between pairs. From this change, we can more quickly ascertain what role different currencies are playing in a market that is more prone to changing its character as long-lasting risk appetite trends dissipate.

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)

CORR-10-07-07-01

CORR-10-07-07-02

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