What are Currency and Currency Pair Correlations
What are currency and currency pair correlations? It is useful to know that some currencies tend to move in the same direction while others move in the opposite direction. For those who want to trade more than one currency pair, this knowledge can be used to test strategies on correlated pairs, to avoid overexposure, to double profitable positions, to diversify risks, and to hedge.
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In the financial world, correlation is the statistical measure of the relationship between two assets. Find out what are currency pair correlations. The correlation coefficient ranges from -1 to +1, sometimes expressed from -100 to 100.
- A correlation of +1 or 100 means two currency pairs will move in the same direction 100% of the time.
- A correlation of -1 or -100 means two currency pairs will move in the opposite direction 100% of the time.
- A correlation of 0 means no relationship between currency pairs exists.
In between -100 and 100 there are different degrees of correlated relationship:
- if the correlation is high (above 70) and positive then the currencies move in tandem.
- if the correlation is high (above 70) and negative then the currencies move in opposite directions.
- if the correlation is low (below 60) then the currencies don’t move the same way.
Where can one find information about current currency correlations?
There are a few websites out there that track the currency correlations between different pairs on different time frames (and periods) and present them in an easy to read table.
What is an example of the strongest positive correlated pair?
EUR/USD and GBP/USD
No matter what time horizon one is looking at, these two pairs seem joined at the hip.
They usually exhibit a very strong positive correlation of 80% or better, which means that when EUR/USD trends up or down, so too does GBP/USD 80-90% of the time, with deviations only occurring 10-20% of the time.
Note: There are always exceptions to historical correlations and sudden deviations in the movement for a number of economic/political reasons. For instance, looking at the correlation chart above on March 7, 2013, it seems the correlation between EU and GU weakened to 30%.
But in a long picture they tend to move together.
Check out the similarity in movement between the two pairs from 2009 to 2011:
Reasons for a strong correlation between EUR/USD and GBP/USD:
- The currency that works as the money is the same (USD). (Note: the first currency in the currency pairs is known as the commodity or quote currency and the second as the base or money. When you buy EUR/USD, you pay to buy EUR). Because both currencies share USD as the money currency, both are strongly affected by the strength of the US dollar and the US economy. When unemployment numbers come out greater than forecast, this is negative for the US dollar, which means that the EUR/USD will rise (weaker Dollar, stronger Euro) and so too will GBP/USD (weaker Dollar, stronger Pound).
- The commodity of both pairs is related to two big European economies, Eurozone and UK, each connected to each other geographically and economically. They are only separated by a strip of water and are each other’s closest and largest trading partner.
Interestingly enough, there are many pairs that move in the same direction as EUR/USD and GBP/USD.
EUR/USD, GBP/USD, AUD/USD, NZD/USD, EUR/JPY, AUD/JPY and NZD/JPY usually move in the same overall direction. However, the amplitude and pattern they make while moving in the same direction can be somewhat different.
Here is all the above pairs side by side from 2006-2010, covering three directional movements, a steady rise (06-08) a sudden fall (second half of 08) and strong recovery (09):
Notice that in all three up and down movements over that 4-year period all the pairs shared the same direction, albeit with different amplitudes. The EUR/JPY rose the highest from 2006-2008, the GBP/JPY fell the hardest in the second half of 2008, and the AUD/USD and NZD/USD made the best recovery in 2009.
What is an example of the strongest negatively correlated pair?
EUR/USD and USD/CHF
These pairs tend to move in mirror opposite directions. While the two pairs are moderately correlated on the weekly horizon, they are very strongly correlated at -96.9 on the daily and -97.7 on the hourly. This means that when EUR/USD trends up, then USD/CHF trends down and when USD/CHF trends up, EUR/USD trends down.
Check out the mirror relationship between the two pairs during the up (06-08, down (second half 08), up (09-10) period between 2006-2011:
Notice the mirror movement in the two pairs, when rises the other descends when one falls the other rises.
Reasons for strong negative correlation between EUR/USD and USD/CHF:
- USD is the base currency of EUR/USD, while it is the quote currency of USD/CHF. They share a USD component, only flipped.
What does this mean? It means when there is a world economic panic, as there was in 2008, the masses are going to seek refuge in the safe haven status of the US Dollar and it is going to get stronger wherever it stands in the pair. The stronger dollar pulls EUR/USD down (weak Euro, strong Dollar) while it lifts the USD/CHF up (strong Dollar, weak Euro). - Outside of the dollar commonality, the Euro and Swiss Franc share a strong geographical and economic relationship. Both are each other’s trading partners and it is neither one’s financial interest to deviate from price parity. In fact, the Swiss Central Bank has been known to intervene when their Swiss Franc has strengthened too much relative to the Euro. The last big intervention was when the Swiss Franc strengthened too much relative to the Euro and its sovereign debt crisis of 2010-2011, and the Swiss Central Bank basically said that it will not allow the EUR/CHF to fall below 1.1000. This policy remained in place until the SNB decided to remove the peg in early 2015.
Interestingly enough, there are many pairs that move in the same direction as the USD/CHF, particularly when they have USD as the first currency quoted.
USD/CHF, USD/JPY, USD/CAD, USD/NOK, USD/SEK, USD/DKK, USD/SGD, all move in the same general direction, albeit with different amplitudes.
Here is all the above pairs side by side from 2006-2010, covering three directional movements, a steady rise (06-08) a sudden fall (second half of 08) and strong recovery (09):
Notice how all these pairs move in lockstep from 2006-2008 until the 2008 crisis unfolds, and then the Dollar explodes in strength, sending all the pairs upwards with differing degrees of force. USD/CAD, USD/SEK and USD/NOK all rose 30% or more, whereas USD/CHF, USD/DKK and USD/SDG rose by only half as much, which leads me to believe that the base quote side of these pairs is in much stronger financial health when faced with a financial crisis.
Noticeably absent from the 2008 upward movement was USD/JPY, which should theoretically move in tandem with all the USD quoted pairs, except for the fact that Japan is such a large industrial powerhouse in its own right and that it has already suffered through an asset bubble from 1986-1991 (17 years earlier than our own in 2008), the collapse of which has lasted close to two decades.
Japan’s long drawn out bubble deflation meant that it was more immune to the financial instability of 2008 and in fact, USD/JPY fell lower from 2008 till now (Dollar weaker, Yen stronger), not because it did not have debt issues of its own (in fact, it has one of the largest), but because it has shouldered its debt burden for so long whereas Europe and United States had their crippling debt problems thrust upon them relatively recently and there was greater fear that some of their nations and states could buckle and fail.
Tips and strategies to make use of correlation information
Avoid Over-Exposure or Doubling Risk
There might be times when you have discovered or created awesome strategies that back-test well on the four currencies (EUR/USD, GBP/USD, AUD/USD, USD/CHF). You might be tempted to trade all your new found strategies thinking that, because they are worked out on different currency pairs, you are diversified.
You know that you should be using 2:1 leverage at any given time, but because you think you are diversified, you are willing to allow 2:1 leverage per strategy pair, which means quadrupling your position, since all four pairs are strongly correlated.
There is nothing wrong with doing this if you have incredible confidence in the performance of each strategy and in the possibility of surviving an aggregate drawdown. With aggregate drawdown, you add the max drawdown of the four pairs. Because of the strong correlation between all four, you are basically magnifying your drawdown by a factor of 4 in the future. One can tell you from hard experience that if you are creating trend-based strategies on different pairs, they will have their drawdown at roughly the same time, usually during a prolonged sideways, volatile market (the bane of all trend strategies).
If you add up your four drawdowns and figure that someday you might come to face a 50% drawdown, you had better reduce your leverage per pair by 50%, or else pick only two pairs to trade.
Doubling Profit while Diversifying Risk
This is the cup half-full side to the cup half-empty rule above. You are looking to double position size by placing your orders on currency pairs trending in the same direction. Why would you want to this? Well, though the drawdown can be doubled, so too can the profit. Moreover, the risk side can be somewhat reduced by moving into an alternate currency pair, versus doubling on the same.
For instance, if your strategy back-tested with 1000 pips per year profit / 200 pips drawdown on EUR/USD, and 700 pips profit / 100 pips drawdown on AUD/USD, you can take advantage of trading the EUR/USD and AUD/USD together (correlation of +70), in order to maximize the profit potential, 1700 pips per year, while having a drawdown of 300 pips, as opposed to a drawdown of 400 pips if you were to double up on the EUR/USD.
You would be increasing profit potential at the same time you would be spreading out your risk. Moreover, oftentimes pairs are subject to sudden jumps in price that seem to get you out at your stops or lure you into false trades. But since your two pairs are not 100% correlated there is a better chance that the sudden jump might not have affected both pairs at the same time, which means that you will not be stopped out or lured into false trades on both pairs. Different monetary policies of central banks have differing impacts on the correlated pairs, such as that one might be less affected than the other or move steadier with less volatility.
Hedging, and Partial Hedging
Full Hedge can be Pointless and Costly
While knowing that EUR/USD and USD/CHF move inversely, there is no point going short both positions at the same time because eventually, they cancel each other, for when EUR/USD falls, USD/CHF rallies. It is almost like you had virtually no positions, except for the fact that you paid spread or commission on both trades, without the potential to profit.
Full Hedge an Intentional Possibility on Deviations (Risky!)
Some people like to lock in full hedges with correlated pairs when they have seen these pairs deviate beyond their normal ranges. For instance, if you see that the GBP/USD has entered the overbought zone of a RSI or Stochastics, while at the same time the EUR/USD is in the oversold zone of a H4 or D1 time frame, one can see this as an interesting scenario to go short GBP/USD and long EUR/USD, with the hope that the pairs will revert back to their normal range and you can eventually profit when they do. While this strategy looks interesting at first glance, it is very risky.
There is really no standard range that these two pairs are forced to exist within, and at times they may move inversely away from each other with great force. You would in effect be trading long the EUR/GBP while it had entered into a downtrend, and if we pull up a 5-year chart history of this pair, you would see that it can enter into sustained long or short trends. You would be severely punished to be the opposite side of such a move.
Partial Hedging Strategies
Back in the early 2000s, a man developed a number of trending strategies that worked well on the long side of EUR/USD and the long side of USD/CHF. He had put these strategies to work thinking that if the dollar were strong, his long USD/CHF strategies would come into play to grab that strength, and if it were weak, then his long EUR/USD would come into play to grab that weakness.
Of course, he could have just traded long and short the EUR/USD, but in his back testing at the time, he had figured that the long side USD/CHF strategies performed much better than the short side EUR/USD strategies. His combination did well for time up till August 2008, when all the currencies started to fall against the dollar (the dollar as safe haven in time of financial crisis and panic), then he realized that his strong dollar strategies (long USD/CHF) were not as equally weighted to the weak dollar (long EUR/USD) strategies as he had thought.
He noticed that his long EUR/USD strategies kept getting triggered, even on the descent, and there were few long USD/CHF that were being brought into play to offset the damage. In hindsight, he would have been better off just trading stop and reverse trending systems on EUR/USD, so that when the systems picked upon the long downward trend, it would have fully ridden it down.
Intermarket Correlations
Just as there are many Intra-market correlations between currency pairs, so too there are many Intermarket correlations between the Forex and other financial markets, such as stocks, bonds and commodities. Traders who develop an understanding of these correlations, along with their important fundamental and psychological relationships, can use them to their advantage, creating strategies that in-bed these relationships.
In this article, we will seek to cover the three most powerful of the Intermarket correlations:
- US Dollar Index and Currencies
- Global Stock Indexes and Currencies
- Gold and Currencies
US Dollar Index and Currencies
The US Dollar Index (USDX) is a futures contract listed on the New York Board of Trade (NJBOT) and Dublin-based Financial Instruments Exchange (FINEX) futures exchanges. The U.S. Dollar Index provides the world with a comprehensive barometer of the value of the U.S. Dollar. Just as the Dow Jones Industrial Average provides a general indication of the value of the U.S. stock market, the U.S. Dollar Index provides a general indication of the international value of the U.S. Dollar. The USDX does this by averaging the exchange rates between the U.S. Dollar and six major world currencies: EUR, JPY, GBP, CAD, CHF and SEK.
The exact weighting of the other currencies in the U.S dollar index are:
| Currency | Weighting |
|---|---|
| Euro | 57.6% |
| Japanese Yen | 13.6% |
| British Pound | 11.9% |
| Canadian Dollar | 9.1% |
| Swedish Krona | 4.2% |
| Swiss Franc | 3.6% |
As you can see, there is a strong European bias to is index, as the Eurozone, United Kingdom, Sweden, and Switzerland total 77.3 percent of the index. Standing on top is the Euro, which comprises 57.6%, due no doubt because the EU is the United State’s super-power equivalent. This European bias is fine for today, as these economies do represent some of the largest in the world, but in the future, if geopolitical relationships were to change, that 57.6% (or any other weighting) becomes more problematic.
If some of the countries within the Eurozone go totally bankrupt and must depart from the EU and the Euro, the index may need to be re-calibrated. If other large economic powerhouses like China decide one day to de-peg the Yuan from the U.S.Dollar, then the index would need some rebalancing to include the Yuan.
The reason why one should look to this index for a gauge of dollar strength, and not to a single currency pair, such as the USD/CAD, is that the effects of bi-national issues on currency prices are minimized by the other currencies in the basket. The United States is almost always in some sort of trade dispute with EU, Japan, China, England, or even Canada, and trade relationships are intricate and new regulations, national or international, can have dramatic effects on currency values.
Though there are less trade disputes with neutral Switzerland, we have seen how its central bank can intervene directly in the market to make sure that their currency does not become so strong as to negatively impact their export sector. Any one country can have their own economic issues and currency fluctuations, but when weighted into the USDX, these fluctuations are smoothed out.
Here is a 6-month comparison of the US Dollar Index with EUR/USD taken on Jan 30, 2012:
Source: Bloomberg
Tip: You can go to Bloomberg and compare any currency pair in the by adding a currency in the Add a Currency box to see the degree of visual correlation.
Notice the mirror-like pattern between the US dollar index and the EUR/USD. When the US dollar strengthens, the EUR/USD falls, and vice versa. You will see more of this mirror-like pattern between the US dollar index and the EUR/USD than between any other currency pairs because of the heavy euro weighting in the index.
What can be done with the strong correlation between the US Dollar Index and other currency pairs one is trading?
Strategy #1: Clearer Picture of US Dollar Movement
When the outlook for the U.S.Dollar seems uncertain, one can look to the U.S Dollar index as a clearer picture of the situation. If the US dollar is not at the moment trending, the index will often be testing key support and resistance levels, and when these levels are broken many traders will react to the breakout from these levels, piling into the new trend. Sure, powerful moves by certain spot currency pairs may direct the direction index, but at the same time, it can be seen that the index itself is provoking change in the U.S. dollar pairs.
Strategy #2: Leading Indicator on Trends and Trend Reversals
The dollar is certainly the main driver in the currency market, the center of the earth through which all the currencies rotate around. The USD index is an indicator to see opportunities since almost all pairs are correlated with USD. If the USD index is trending weaker, we can feel more confident in buying EURUSD or selling USDCHF, and if it is trending stronger, we can feel more confident in selling EURUSD or buying USDCHF.
Sometimes, because the USD index is a leading driver of the currency markets, it can provide a faster trend reversal signal on the majors than watching any one of the majors themselves. It behooves any serious trader to keep on eye on it.
Sources for US Dollar Index:
Finance Websites that provide free charting:
Global Stock Indexes and Currencies
If any of us have any knowledge of finance prior to trading currencies, it is probably in the realm of trading stocks or the stock indexes. Though there is 100 times more money traded on forex than the US stock markets, there is no doubt more people looking at or trading the US stock markets than the currency markets.
It has only been the last 10 years that retail traders have jumped upon the currency markets, whereas retail traders and investors have been trading US stocks since the 19th century. Every major financial cable network or radio show has to cover the movements of the Dow Jones every day, and the currency markets only get brief coverage, if at all. Everyone knows something about stocks, whereas few know anything about forex.
This greater popularity of the stock markets carries with its own advantages. As we have noted in our technical analysis in Forex section, many technical indicators or chart patterns are more powerful when more popular. Popularity lends to them a self-fulfilling power.
For instance, there might not be any magical reason why the 200-day moving average has any more significance than any other length and time frame other than the fact that most people are told that it is the length and time frame to watch out for, and when it is crossed on the upside, this is the “golden cross” for a strong bullish market. The same holds true for markets.
The more popular the market, the more any indicator works better for it. Thus, by extension, if more people are looking at one popular indicator on one popular market, like the Dow Jones, then it is going to have more significance than the same indicator on a less popular market. With many more eyes trying to decipher the movement of the US stock markets, then any new trend discovered on it can act as an early warning on any strongly correlated currency pair.
Here is a comparison of the Dow Jones with EUR/USD, GBP/USD, AUD/USD from Jan 2010 to Jan 2012:
Source: Google Finance
Notice how the three currency pairs move in similar directions with DJ, though in different amplitudes. In the graphic above it is clearly seen that the AUD/USD has maintained the closest correlation to the DJ, whereas EUR/USD and GBP/USD did not rise as much in that two years, due no doubt to the European sovereign debt crisis.
If you find currency pairs like the AUD/USD that are more correlated to the DJ or other financial indexes, what can be done with these correlations?
Strategy #1: Leading Indicator on Trends and Trend Reversals
There are probably more people looking at the moving averages and trend lines on Dow Jones than on any one currency pair. This means that when these lines are drawn, they stand up as more accurate and reliable because of their greater degree of popularity and by extension, self-fulfilling prophecy.
When the Dow Jones breaks up through the famous 200-day moving average, it signals to all stock traders that the stock markets are bullish, and to all currency traders that any DJ correlated pairs like AUD/USD are also likely to be bullish. Similarly, when support and resistance lines are drawn on the Dow Jones, and there is a strong break up or down through these lines, one can expect a strong move in the DJ that is closely followed by a strong move in DJ correlated currency pairs.
Tip: We have been mentioning the DJ correlation as only one possible correlation. There are many more global financial indexes than the DJ that may prove to have more reliable relationships and act as a faster leading indicator. We advise you to look at all the global indexes in relationship to all the major and minor currency pairs.
Sources of Global Indexes
Finance Websites that Provide Free Charting:
Google Finance
Investing.com
Bloomberg
Gold and Currencies
The origins of correlations between gold and forex are many. Gold is seen as an alternative to currency. It is seen as a safe haven in times of uncertainty. Some central banks are adding to their gold reserves. It benefits from near-zero interest rate levels. Lastly, it is viewed as an inflation hedge.
The US Dollar was once backed entirely by gold, thus earning the term “greenback” but by the 1970s, during an inflationary cycle, Nixon axed the connection to gold, and since then the dollar has been in a steady fall. The Swiss Franc (CHF) was once 40% backed by gold and silver, but has abandoned this “backing” when the Swiss had to sell much of its gold and silver reserves to join the IMF by 2006.
Today not a single currency is backed by gold or silver, as all nations have inflated their currencies to unprecedented levels in the last 50 years. Most countries do own gold but their gold reserves are not explicitly owned for the purposes of backing their currencies.
At different times in the last 20 years, gold has enjoyed a strong correlation to some currency pairs, particularly currency pairs known as commodity pairs (AUD/USD, NZD/USD and USD/CAD). While CAD is correlated with oil, its correlation is not that strong as compared to AUD, NZD and CHF with gold. AUD has the strongest tie to gold, not because it has the largest gold reserves, but because it is one of the largest gold producers.
Australia remains a major producer of gold, the fourth-largest producer in the world, coming in behind China, South Africa, and United States, and as a result, it is only natural that AUD/USD follows a similar pattern to gold. The currency has moved in lockstep to the commodity until mid-2008. Since mid-2008, the correlation has weakened somewhat, with gold on a bullish run in a much greater degree than AUD/USD.
Here is a comparison of XAUUSD (Gold) and AUD/USD over the last 5 years, from Feb 2007 to Feb 2012:
Source: Bloomberg
From 2007 till 2012, AUD/USD moved in the same directions as gold but in different amplitudes. AUD/USD fell much harder than XAU/USD in the financial crisis of 2008, and it recovered from the fall 2 years later in Sept 2010 whereas Gold had recovered in Feb, 2009. XAU/USD had gained an extraordinary 180% in the last five years, whereas AUD/USD has gained a handsome 40%.
Gold is known as Anti-dollar. When USD rises, gold prices fall and when USD falls, gold prices rise. It does not necessarily mean that Gold and the USD dollar index are negatively correlated. The U.S. dollar index has such a strong euro weighting; so instead, it is more reasonable to say that USD quoted pairs, like USDCHF and USDJPY are negatively correlated with Gold.
Here is a comparison of XAU/USD (Gold) plotted against USD/CHF and USD/CHF over five years, from Feb 2007 to Feb 2012:
Source: Bloomberg
Notice when gold had been gaining extraordinary strength in the five years chart above, so too have been the Franc and Yen, as reflected in the steady fall of USD/CHF and USD/JPY. The Franc has gained 25% and the Yen has gained 35%, almost as much as the Aussie’s 40% without the same amount of volatility. Why this correlation? Because when gold gains strength, it is doing so against the U.S.dollar.
Similarly, when the U.S dollar is weakening, the USD/CHF and USD/JPY are descending down (weaker dollar / stronger CHF or JPY). But the Swiss franc retains a secret correlation with gold.
USD/CHF and Gold. For close to 80 years, the Swiss franc has been considered a safe-haven with virtual zero inflation because of its legal requirement to have 40% be backed by gold reserves. However, its 80-year link to gold was terminated on May 1, 2000 following a referendum. By March 2005, following a gold selling program to join the IMF, the Swiss National Bank holds 1,290 tonnes of gold reserves (20% of assets, half as much as before). Nevertheless, the anonymity and neutrality of Switzerland make the Swiss Franc a safe-haven during turbulent times.
The USD/CHF performs to parity with gold prices, with the dollar representing an “anti-gold” wager and the Swiss Franc being a partial gold hedge. More recently, since the Global Financial Crisis (2007-2012) and concurrent Sovereign Debt Crisis (2008-2012), investors have been turning to the Swiss Franc as an attractive European alternative. It is a partially gold-backed currency and it is also one of the few currencies in Europe that isn’t the Euro.
Can these strong correlations between gold and AUD/USD or USD/CHF be used to profitably trade these pairs? The answer is YES.
Strategy #1: Leading Indicator on Trends and Trend Reversals
There may be times when it is hard to know what future direction pairs like USD/CHF and AUD/USD are going to take. They may be currently stuck in a range or sideways market and you don’t have any clue as to when and in what direction a trend might development. This might be the moment to consult a leading indicator like the Gold chart. Here you pull out the daily gold chart and apply to it a 200-period moving average to see if it is above it (for an uptrend) or below it (for a downtrend). Then, if you detect that gold is trending, you can find a way to jump into long AUD/USD or short USD/CHF on retracements in the price.
The gold correlated pairs may even prove to be leading market indicators on gold. Sometimes it is hard to determine which is going to be the leading market indicator (which is going to lead which) — gold or the aforementioned gold-correlated currencies. Sometimes you just need to experiment and backtest different indicator based strategies for entries/exits transplanted from a gold chart to AUD/USD or USD/CHF charts, and then alternately, entries/exits transplanted from AUD/USD or USD/CHF charts to a gold chart. You may be surprised to learn that there is a currency pair that acts as a powerful leading market indicator for deciding the direction of gold. In that case, you may try trading gold as a CFD in many non-US forex brokers.
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