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 EURUSD and AUDUSD is different than having a portfolio comprised of EURUSD and USDCHF. As indicated in the tables below, through the Monday of August, the dominance of the US dollar in fundamental schemes and turn in rate expectatiosn led to a relatively strong correlation (0.75) between EURUSD and AUDUSD. On the other, Switzerland’s trade ties with the Euro-Zone economy kept the euro correlation to USDCHF (-0.90) almost exactly on opposite ends of the spectrum. This means that having long exposure in both EURUSD and long USDCHF would generally negate profit or loss because when EURUSD rallies, USDCHF 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. On the other hand, holding long EURUSD and AUDUSD 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. For the past year, the carry trade has been a proiminent market driver; but large yield differentials have kept the the tide from over taking all pairs – until recently. With the market adjusting to the Australian central bank’s new dovish approach to monetary policy, there has been a significant increase in the negative relationship between AUDUSD and USDCHF. Over the past 12 months, the hold out in Aussie rates and small carry potential in USDCHF kept the correlation between the two pairs relatively low (-0.29). However, through the past month, the sharp drop in the Aussie dollar has tightened the relationship (-0.75). Shifts such as these can be partially explained by changes in the severity of monetary policy or changes in unique domestic 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.
Written by: John Kicklighter, Currency Strategist for DailyFX.com
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