Forex Correlations Show Oil and Gold Outlook Key to US Dollar Forecast

DailyFx · September 8, 2008, 12:10pm

Crude oil prices continue to trade virtually in tandem with the Euro and US dollar, while the highly risk sentiment-sensitive Japanese Yen has closely followed movements in the US Dow Jones Industrials Average. Given strong cross-market correlations, it has become increasingly clear that forex traders should monitor developments in commodity and equity markets as it relates to their currency positions.

Forex Correlations Summary:

Forex correlations against Oil, Gold, and the Dow Jones Industrials Average for the past 20 trading days:

Crude oil prices continue to trade virtually in tandem with the Euro and US dollar, while the highly risk sentiment-sensitive Japanese Yen has closely followed movements in the US Dow Jones Industrials Average. Given strong cross-market correlations, it has become increasingly clear that forex traders should monitor developments in commodity and equity markets as it relates to their currency positions.

In terms of weakening correlations, it is interesting to note that the Australian dollar has virtually stopped tracking movements in the US Dow Jones Industrials Average. Given that the broader G10 Carry Trade has recently picked up its correlation to the DJIA, the fact that the AUDUSD is largely moving independent of the key risk barometer suggests that there are other more important movers of Australian Dollar volatility. Namely, we have seen interest rate outlook take center stage in forcing AUD moves, and the Reserve Bank of Australia’s first interest rate cut in seven years bodes poorly for the highly carry trade-sensitive currency.
Strong Forex Correlations

                                      [B]Euro/US Dollar and Oil Futures[/B]
         The correlation between the EURUSD and NYMEX Crude Oil futures has recently hit its highest levels since the inception of the euro—underlining the importance of commodity prices in determining the trajectory of the US dollar.  It seems that the relationship between oil and the US dollar remains stable, and we would argue that it will be important to watch for any significant price moves in oil while trading the US dollar and vice-versa.

Australian dollar and Reuters/Jefferies CRB Index
The relationship between the Australian dollar and commodity prices has never been stronger; a rolling 1-year correlation between the AUDUSD and Reuters/Jefferies CRB Index now trades at its highest since the Aussie became a free-floating currency in 1984. As is the case for the EURUSD, the fact that the US dollar itself is moving almost lock-step with oil futures explains a good deal of this dynamic. AUDUSD outlook will largely depend on outlook for key commodities.

Forex Carry Trade Basket and the US Dow Jones Industrials Average

         The correlation between the Forex Carry Trade basket and the Dow Jones Industrials Average is considerably off of the heights seen through 2007, but we nonetheless see that the Japanese Yen has significantly picked up its correlation to risky assets through recent trade. Such a dynamic emphasizes that carry traders and USDJPY speculators should closely monitor developments in global equity markets.

Weak Forex Correlations:

                                      [B]Australian Dollar and the Dow Jones Industrials Average[/B]

         One notable exception to the aforementioned carry trade/Dow Jones Industrials correlation remains the Australian Dollar. The AUDUSD continues highly related to global gold and other key commodity prices, but it seems as though its previously strong link to equities has since faded. Part of this is the fact that it has very much been moving to shifts in interest rate expectations, as the Reserve Bank of Australia recently cut interest rates for the first time in seven years. As such, it will likely be more important to watch developments in commodities and interest rate markets as it relates to AUDUSD trading.