Inter Market Correlations
Currency Correlation
2010-01-05
most retail forex traders lose sight of What is most important – why currencies change value?
To understand that, you must look beyond the currency pairs themselves and analyze other markets. If you have ever said, “I’m just a forex trader… I trade only currencies,” then you have walled yourself in and will find yourself at a severe disadvantage, as your analysis will be limited to ‘what’ has happened in forex and you will never really know ‘why’ it happened.
Currencies’ valuations change when money crosses borders. Money flows around the world as businesses and banks conduct their normal day-to-day activities. Money also flows from one market to another as investors put their money to work around the world. Whether it is a European car manufacturer building a car plant in Australia, a hedge fund manager in London buying into the S&P 500 in America, or a Japanese housewife carry trading the Turkish lira to collect the high interest, local currency is traded for foreign currency.
Some currencies are naturally going to have a higher demand than others and, as with any other commodity, the higher the demand the higher the valuation. Look to the intermarket for the demand trends that will affect the ebb and flow of money and you will see a similar waxing and waning of currency valuations.
In the chart a thin blue oval represents strong positive correlations, so in figure 1 you are looking for very thin ovals… the thinner the better. For example, if oil is going up, the EUR/USD usually goes up as well. A thin red line represents a strong negative correlation –if oil is going up the USD/CAD usually goes down. Anything else suggests moderate to negligible correlation and is not usually useful for trading purposes.
Correlations change based on changes in demand. Never set your trading strategies in stone. As the global economic, political and social environment changes, currency correlations also change. This is why every hedge funds on the planet, has a quantitative analyst on the team to constantly crunch the numbers and update correlation statistics. For example, in 2007 the stock market in the United States tended to fall when oil prices rose. Now oil prices often rise when the stock market rallies – almost a complete reversal of strategy. Correlations can change from week to week, not just year to year.
In May, watching the gold and oil prices would have been very helpful for trading the majors. It seems that the USD usually lost value when these commodities were rising in price. You will notice that the EUR, GBP, CAD, CHF, AUD and NZD all rose against the USD when oil and gold were gaining value. It would have been difficult to have found a weaker currency in this situation.
Another interesting correlation is the GBP/JPY, a favorite currency pair for thrill seekers. It traded an average daily range of 274 pips throughout May 2009, as compared to only 177 pips on the EUR/USD. If you were trading BP/JPY, you should have also had a 10-Year T-Note chart open. Why? They had a strong negative correlation. If the 10-Year T-Note was tanking, the GBP/JPY was likely to be skyrocketing.
Currencies can also be correlated with each other, because many of the trends that affect one economy also affect another. For example, if money is flowing into the euro zone, perhaps some of the money could also flow into Switzerland. Or if money was flowing into Australia, couldn’t New Zealand also benefit? Surely. If the United States falls into recession, are the Canadian and Mexican economies going to boom? Not likely. Bust is more probable. There are many direct and indirect relationships. However, they are easily seen by watching currency correlation data.
If you were long AUD/JPY, you should also have been long NZD/JPY. If you were short CAD/JPY you should also have been If you were long AUD/JPY, you should also have been long NZD/JPY. If you were short CAD/JPY you should also have been short GBP/JPY. However, if you were long CAD/USD you should have been short EUR/USD. An experienced trader understands these well established relationships.
Experienced traders would find it interesting that, if you were short USD/CAD you would not always have done well if you also were long CAD/JPY. There is only a moderate correlation. Or if you were long GBP/CHF you should also have considered buying EUR/CHF, right? Not always. They too are only moderately correlated. How about the correlation between the EUR/CHF and EUR/JPY? Believe it or not, they have little to no correlation at all. Same thing with the USD/JPY and AUD/JPY; perhaps half the time they traded the same way and the other half they traded in the opposite direction…in any case, trading them together would not have proved helpful.
This goes to show that fundamental analysis is strategically important to forex traders. Even if you don’t trade stocks, bonds or commodities, watching the intermarkets is extremely important. If you understand why a currency is moving up or down, you can develop a bias and plan your trades by choosing the correct currency pair, trading it in the correct direction and planning your trade setup well in advance. If will help you develop confidence in your trading. For long-term trading success in forex, look outside the currency markets to profit within.
