Correlation in the Forex market: tips for application
Have you ever noticed that some currency pairs move in the same directions? For example, the pair NZD/USD in most cases repeats the movement pattern of AUD/USD. This phenomenon is calledcorrelation".
So, Currency correlation - a measure of mutual dependence of two currency pairs. The correlation coefficient is presented in decimal format and ranges from +1.0 to -1.0.
- Correlation +1 (positive, direct) means that the two currency pairs 100% time move in the same direction.
- Correlation -1 (negative, inverse), on the contrary, means that the two pairs of 100% times are moving in opposite directions.
- Zero correlation meansthat the two couples do not depend on each other in any way.
The most striking examples of pairs with direct correlation are EUR/USD and GBP/USD, AUD/USD and NZD/USD, USD/CHF and USD/JPY.
Good examples of inversely correlated pairs are EUR/USD and USD/CHF, GBP/USD and USD/JPY, USD/CAD and AUD/USD, USD/JPY and AUD/USD.
How to use currency correlation in trading?
Understanding currency correlations will allow you to avoid making dangerous trading decisions. Correlations are especially important in medium- and long-term trading.
For example, it should be understood that unidirectional positions in positively correlated pairs increase the amount of potential losses. For example, we know that EUR/USD and GBP/USD traditionally have a strong direct correlation. This means that buying EUR/USD and GBP/USD at the same time actually doubles your risk. If your expectations are not met and the euro is getting cheaper against the US dollar, the pound is likely to follow the euro down.
A similar situation arises when oppositely directed positions are opened in two pairs with opposite correlation (for example, simultaneous purchase of EUR/USD and sale of USD/CHF).
Besides, simultaneous multidirectional trading on two correlated pairs does not make much sense - you actually have no position. For example, buying EUR/USD and selling GBP/USD at the same time is counterproductive. Any market movement increases your profit on one pair, but decreases it on the other. You may end up closing at a loss due to the difference in pip values. The same applies to unidirectional positions on inversely correlated pairs (for example, buying EUR/USD and USD/CHF at the same time).
Board of Trade
Let's imagine that the pair EUR/USD is testing an important resistance level. Before buying the EUR on a breakdown, we would recommend looking at how other dollar pairs are behaving at the same time. If the dollar is weakening against most of the major currencies, we can assume that the current breakdown of the EUR is not false.
Correlation of currencies and commodity prices
The foreign exchange market interacts closely with other financial markets. If you trade in currencies of commodity-exporting countries, carefully study the factors affecting the price of that country's "core" resource and try to make your own predictions about it.
Consider the example of the Australian dollar (AUD). Key items of Australian exports are iron ore, dairy products and gold, so the state of the economy and the rate of national currency is directly dependent on market prices for these goods. Australian dollar strengthens when the prices of these goods rise, and conversely, declines when prices fall.
As you can see from the charts, between the price of gold and the AUD/USD pair there is indeed a long-term positive correlation. However, in short-term periods the correlation may decrease. For example, a sharp sell-off in the U.S. stock market, as right, weakens the binding rate of AUD/USD to gold.
Another good example of currencies correlating with commodities is the Canadian dollar (CAD) and oil. Canada is the largest supplier of oil to the United States, so if global oil prices rise, you should think about long-term purchases of the CAD.
Correlation of exchange rates and the stock market
Correlation of USD and S&P 500
The growth of the stock market is usually accompanied by a strengthening of the national currency, but there are also special cases. For example, the correlation between the S&P500 and the U.S. dollar (USD) is not constant. On the one hand, a cheap dollar is a positive factor for the U.S. stock market: the competitiveness of U.S. goods on global markets is increasing, which leads to higher profits for companies and, consequently, their shares. That is why the launch of the quantitative easing (QE) program in the U.S. has lifted stock indices to record highs. However, in addition to the exchange rate, U.S. stocks are affected by many other local and global factors. The dollar exchange rate and U.S. stock indices are generally a reflection of underlying economic processes.
In December 2013, the U.S. Federal Reserve announced a gradual withdrawal from the QE program, as well as a possible rate hike in early 2015. There are concerns that the tightening of monetary policy FED could cause a collapse in the stock market, as cheap liquidity in the market would be reduced. Meanwhile, the U.S. dollar could strengthen. Despite this, many economists are not inclined to view QE rollback and rate hikes as a definite negative factor. The reduction of the volume of monetary stimulus signals that the largest economy in the world will come out of the crisis, and therefore it is a positive signal for the capital markets. Moreover, the U.S. authorities are cutting QE gradually, making decisions based on the dynamics of economic indicators. There is a high probability that in the coming months there will continue to be weak positive correlation of the dollar exchange rate and stock indices.
Correlation of JPY and Nikkei 225
The Japanese yen and the Nikkei 225 stock index are another curious example of a changing correlation. The yen and the Nikkei maintained a positive correlation until 2005, but then it changed to a negative correlation. This paradox can be explained by the fact that Japan had exceptionally low interest rates in 2005-2007, which made the yen the main funding currency in operations "carry trade"(borrowing in the currency of a low interest rate country, converting and investing in the currency of a high interest rate country). The yen was declining amid an abundance of such transactions (i.e., the USD/JPY was strengthening). Japan's exporters benefited from a cheaper currency, and as a result, the Nikkei Index was also on the rise.
This situation persisted until the start of the global economic crisis in 2008. At that tense time investors began to get rid of risky assets, and bought "safe" yen. As a result, the JPY went up, which had a negative impact on the profits of Japanese exporters and, consequently, on the Nikkei index.
In 2012, the Bank of Japan has chosen a strategy to actively fight deflation, based on the depreciation of the national currency. A sharp drop in the yen led to a rise in Japanese stock markets. Thus, we see that the inverse correlation between the yen and the Nikkei is still in place today.
