Through the close fundamental ties between the Euro Zone, UK and Swiss economies; we would expect to see a significant correlation develop in their respective currencies as the health of one major player will impact its peers. However, growth potential is only one of a few prominent fundamental themes taking charge of the currency market recently. Another, particularly strong driver in this mix over the past months has been risk appetite.
The following is our monthly correlations update for September. 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 six-month 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 example, having a portfolio that consists of the EURUSD and GBPUSD is different than having a portfolio comprised of EURUSD and USDCHF. Through the close fundamental ties between the Euro Zone, UK and Swiss economies; we would expect to see a significant correlation develop in their respective currencies as the health of one major player will impact its peers. However, growth potential is only one of a few prominent fundamental themes taking charge of the currency market recently. Another, particularly strong driver in this mix over the past months has been risk appetite. Yet, a stalled advance in risk appetite in sentiment behind equities, fixed income and currencies has clearly shifted the focus on recovery efforts and what it means for monetary policy. As such, we have seen over the past month that the natural highly negative correlation between EURUSD and USDCHF has firmed (-0.93) over the past month, while the Euro and pound-based majors have retained a high, positive correlation (0.75). We will have to watch these relationships as they develop over time, as we can use this form of analysis to gauge the influence that either growth or risk appetite have over the market. In the meantime, when using these relationships in trading, remember that the correlations are not exactly perfect, they change with time, and pip costs are different and therefore need to be account for.
Taking a different approach to this data, we can clearly see the shift in fundamental themes behind the market over time. Taking another look at the link between EURUSD and USDCHF, the one-year correlation was standing at 0.82. This is still very high; but considering the Swiss economy’s dependency on the health and actions of the Euro Zone, it would not be unreasonable to expect higher. This period was partially influenced by the intensified efforts of risk aversion that forced market participants to weigh the safe-haven aspects of the Swiss franc against its US counterpart. As fear subsided, normal risk/reward consequences were once again factoring in and hence we see the relationship between the two pairs tighten through more recent months (-0.93 over the past month and -0.94 for the past three). Overall, having this knowledge will allow traders to effectively diversify and manage their portfolios over time.
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 09/01/09)
Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at <[email protected]>