Forex correlations

What is a currency pair correlation?

Correlation is the interconnection between two different currency pairs where they move either in the same direction, which is called a positive correlation, or in opposite directions, which makes it a negative correlation.

Essentially, a correlation is when one asset repeats the movement of another, i.e., when they are able to move synchronously in the same direction. Correlation is possible between different instruments, such as currency pairs, stock indices, commodities, etc. Currencies may follow indices, commodities, and/or other currencies. For example, if a country’s economy depends on the oil market, the price of its national currency may also depend on oil futures performance, i.e., if oil prices rise, this country’s currency rate rises as well, and vice versa, if oil prices drop, the currency rate declines.

What is a correlation coefficient?

Traders use the Pearson correlation coefficient, also commonly known as the correlation coefficient, to determine the degree of correlation, using the following formula.

The correlation coefficient represents the ratio between the covariance of two variables – in this case, the prices of assets X and Y – and the product of their standard deviations. Naturally, all calculations are now performed by corresponding programs.

Values below -0.70 and above +0.70 are deemed strong, and values between -0.70 and +0.70 are deemed weak, i.e., instruments with correlation in the negative range starting from -0.70, move in relatively the same manner but different directions, and instruments with correlation in the positive range starting from +0.70, move in tandem.

What are the benefits of knowing currency pair correlations?

Instrument correlation may be used to predict the movement of an instrument, which is led by another instrument. For instance, if the leading currency goes up, you can open a long position for the led instrument, or if the leading instrument reverses, you can close the existing position. The same principle goes for negative correlation but vice versa. Correlation is also used to limit losses from an open position by opening an opposite trade for the led currency or by opening a trade in the same direction if these instruments have a negative correlation. This is called hedging.

Correlation of currencies and commodities

Traditionally, the most prominent correlation of currencies and commodities is the correlation of USD/CAD and oil. Canada is the seventh largest producer of oil in the world, and this country’s economy strongly depends on oil export. That’s why an increase in oil prices has a positive effect on the CAD price performance, causing the USD/CAD exchange rate to go down. A decrease in oil prices has a negative effect, and the USD/CAD exchange rate goes up.

Prices of copper and gold have usually been a good indicator of potential movements in the AUD/USD pair. Mining industry, particularly copper and gold mining, plays an important role in Australia’s economy. That’s why a rise in the prices of these metals may promote an increase in the AUD/USD rate, and a price drop may cause the rate to decline.

JPY and gold prices can also move in the same direction because both of these assets traditionally serve as the so-called safe-haven assets that are in demand during economic crises or sales in capital markets.

Correlation of currencies to stocks and other assets

To determine potential movements in the USD/JPY pair, experienced traders use the dynamics of the U.S. stock indices, especially S&P500. As we mentioned before,, a drop in indices occurs when investors refuse risky assets and promote purchases of JPY. And vice versa, when speculators are determined to risk, they get rid of JPY and buy USD. Thus, an index drop may precede the USD/JPY rate drop, and an index rise may precede the USD/JPY rate rise. In this case, S&P500 is the leading asset, and USD/JPY is the led asset.

USD rates may be influenced by the rates of the U.S. long-term bonds. Yield growth and a decline in bond quotations support the U.S. dollar, and yield decline and a higher demand for bonds put pressure on the USD. Here, the USD acts as a safe-haven asset.

How to trade correlated currency pairs

There are no particular strategies for trading correlated currencies. If a trader has an open short position for EUR/USD, he can reduce the risk by opening a short position for USD/CHF. In this case, profits from selling USD/CHF may compensate for possible losses from selling EUR/USD, and vice versa.

Selling AUD/USD may be hedged by buying NZD/USD, buying EUR/USD may be hedged by selling GBP/USD, and selling EUR/AUD may be hedged by buying EUR/NZD. In these and other cases, you should always consider potential movements in cross rates of currencies. For instance, the effect of hedging the buy of EUR/USD with the sell of GBP/USD may be canceled out at best or bring losses at worst if the EUR/GBP cross rate declines actively. Thus, GBP/USD will rise, and EUR/USD will either be flat or go down, which will cause a very bad situation for a trader.