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As Volatility Picks Up, Correlations Reveal Currencies’ Shifting Position on the Risk Spectrum

As Volatility Picks Up, Correlations Reveal Currencies’ Shifting Position on the Risk Spectrum

2010-05-11 21:54:00
John Kicklighter, Chief Currency Strategist
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Forex Correlations (May): How Do Currencies Trade In Relation To Each Other?

The following is our monthly correlations update for May. 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.

Sometimes the titles of ‘risky’ and ‘safe haven’ - when applied to a particular currency - are doled out without consideration as to what makes a currency high or low on the yield or risk spectrum. Just like investor sentiment itself, currencies are not static in their relationship to underlying risk trends. Therefore, it is important to look beyond the strict academic notion that the a high yield currency like the Australian dollar is permanently considered a carry currency that will appreciate when other growth-sensitive assets advance; while the US dollar is forever a harbor for safety and nothing more. Through correlations, we can better see that the lines of separation are not strictly black and white. Already, some of the highest yielding currencies are starting to lax in their link to risk trends. For example, despite maintaining a 1.00 percent benchmark lending rate (third highest amongst its most liquid counterparts), the euro’s outlook has been so irrevocably undermined by recent troubles in Greece that the traditional ebb and flow in speculative are warped. On the other side of the coin, the traditional funding currency, the Swiss franc, has seen its safe haven appeal dissipate as local regulators open up the nation’s banking system to international scrutiny.

However, the shifting of the tides for the euro and the franc are perhaps overtly obvious given the fundamental changes that have occurred over time. There are other currencies that are perhaps more subtle; but nonetheless altering their market-wide dynamic. For a surprising comparison, we look to USDCAD and USDJPY. Though the Canadian dollar currently has a low benchmark yield, the outlook for this rate of return is expected to shoot higher in the near future. This has given the ‘loonie’ an appeal akin to those units that are more traditionally placed in this category (like the Australian dollar). Then why does the USDCAD and USDJPY have a -0.64 correlation (meaning they move in opposing directions the major of the time) over the past month? Though the US and Japanese currencies both have extraordinarily low lending rates, the dollar has increasingly taken on the qualities of a carry currency over recent months thanks to a growth and interest rate forecast that is more stable and hawkish than many of its counterparts. Another interesting highlight is the correlation between USDCAD and NZDUSD. Despite having a robust relationship with its Aussie dollar-based counterpart (-0.77), the link between the USDCAD and NZDUSD is weak (-0.36). This shows us that even a currency at the top of the interest rate spectrum (the NZD) can see its response to risk trends breakdown.

And, looking at this data from a different angle – a perspective that further shows the fluidity of these market relationships – we come to the one-month trailing correlation between EURUSD and USDJPY. Through March, the two would move opposite each other the majority of the time (-0.50); but just this past month, that relationship flipped to a positive association (0.34). In the former month, the dollar was considered the funding currency for EURUSD and the yen in USDJPY, putting them on the same side of the coin. Yet, come April, troubles in Greece would leverage the dollar’s allure as a safe haven that promised rate hikes well before the euro could find traction.

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 05/03/10)

CORR511a

CORR511b

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