Forex Correlations

Forex (foreign exchange) correlations refer to the interconnectedness between different currency pairs in the global foreign exchange market.

By understanding these correlations, traders can make more informed decisions, manage risks more effectively, and diversify their portfolios.

In this article, we’ll explore key aspects of forex correlations, including types, common pairs, factors affecting them, and their practical applications.

We also provide a chart of FX correlations. However, when viewing these correlations, they come with the caveat that correlations change and are fleeting byproducts of the deeper cause-effect drivers of them.

Key Takeaways – Forex Correlations

• Understanding forex correlations is crucial for forex traders to manage risk and capitalize on potential opportunities.
• By analyzing factors such as currency relationships, commodity prices, risk appetite, interest rates, inflation, economic growth, and political events, traders can develop a comprehensive understanding of the forex market’s interconnected dynamics.
• This knowledge can be leveraged to enhance trading strategies, manage risk, and improve overall performance in the foreign exchange market.

Types of Forex Correlations

There are two primary types of forex correlations: positive and negative.

Positive correlation

When two currency pairs move in the same direction, they are said to have a positive correlation.

For example, if the EUR/USD and GBP/USD both rise, they are positively correlated.

Negative correlation

When two currency pairs move in opposite directions, they are said to have a negative correlation.

For example, if the EUR/USD rises and the USD/CHF falls, they are negatively correlated.

Common Forex Pairs and their Correlations

Here are some common currency pairs and their typical correlations:

EUR/USD and GBP/USD

Often positively correlated due to the close economic ties between the European Union and the United Kingdom.

EUR/USD and USD/CHF

Typically negatively correlated since the Swiss franc is considered a safe-haven currency and tends to strengthen when the euro weakens. And obviously, the USD is flipped from denominator to numerator in these pairs.

AUD/USD and NZD/USD

Generally positively correlated due to the similar economic structures and geographic proximity of Australia and New Zealand.

USD/CAD and USD/NOK

Often positively correlated because both the Canadian dollar and the Norwegian krone are considered commodity currencies, with oil being a significant export for both countries.

Forex Correlations via ETFs (Chart)

An easy way to track FX correlations is through their representative ETFs.

In this case, we can look at ETFs like:

• FXA (AUD)
• FXB (GBP)
• FXC (CAD)
• FXE (EUR)
• FXF (CHF)
• FXY (JPY)
• UUP (USD)
• GLD (Gold)

We consider gold a currency because of its long-enduring role as a global reserve asset and the fact that it exhibits characteristics closer to that of a currency than a traditional commodity.

Factors Affecting Forex Correlations

Several factors can impact the strength and direction of forex correlations:

Economic policies

Central bank decisions, such as interest rate changes and quantitative easing, can influence currency correlations.

For example, if two central banks have similar monetary policies, their respective currencies may exhibit a positive correlation.

Geopolitical events

Political events and global crises can affect currency correlations.

For example, Brexit significantly impacted the correlation between the GBP/USD and EUR/USD.

Market sentiment

Market sentiment can cause correlations to change, especially during periods of heightened risk aversion or risk appetite.

When investors seek safe-haven assets, they tend to buy the Japanese yen or Swiss franc, leading to negative correlations with more pro-cyclical currencies like the Australian dollar or the New Zealand dollar.

Commodity prices

Since some currencies are tied to the performance of specific commodities (like the Canadian dollar with oil or the Australian dollar with iron ore), fluctuations in commodity prices can impact currency correlations.

Trade relationships

Countries with strong trade connections may exhibit positively correlated currencies, as their economies often move in tandem.

For example, the close trade relationship between Australia and China can cause the AUD/USD and USD/CNH pairs to be positively correlated as their economies are interlinked.

Practical Applications of Forex Correlations

Understanding forex correlations can be useful for traders in various ways:

Diversification

By recognizing currency correlations, traders can create a diversified forex portfolio, reducing risk by avoiding overexposure to a single currency or correlated currencies.

Diversification by currency is an underrated component of overall portfolio diversification.

Risk management

Traders can use correlation data and an understanding of the mechanics of these correlations to manage their risks effectively.

Trade strategy

Recognizing correlations can help traders develop more nuanced trading strategies.

For example, if a trader believes that the EUR/USD will rise, they might also decide to trade the GBP/USD, given their typical positive correlation.

Hedging

Forex correlations can be used for hedging strategies, where traders take opposite positions in two negatively correlated currency pairs to reduce risk.

For example, if a trader has a long position in EUR/USD, they could open a short position in USD/CHF to hedge against potential losses due to their negative correlation.

Correlations are not static

It is essential to note that forex correlations are not static and can change over time due to various economic and geopolitical factors.

As a result, traders should regularly monitor correlation data and adjust their strategies accordingly.

Key Aspects to Analyzing Forex Correlations

Below we have some key aspects to consider when analyzing forex correlations.

We covered a bit about the first three above, then we’ll get into some other aspects as well.

Currency Correlations

Currency pairs often exhibit a strong positive or negative correlation based on the relationship between their respective economies.

For example, as we mentioned earlier in the article, the EUR/USD and GBP/USD pairs typically have a strong positive correlation, as both the Eurozone and the United Kingdom economies are closely linked.

Conversely, the USD/CHF and EUR/USD pairs have a strong negative correlation, as the Swiss Franc is often considered a safe-haven currency, and its value tends to rise when the Euro or the US Dollar fall.

Commodity Correlations

Currencies of countries that are major producers or consumers of commodities often exhibit strong correlations with commodity prices.

The Canadian Dollar (CAD), Australian Dollar (AUD), and New Zealand Dollar (NZD) are commonly referred to as “commodity currencies” because their economies are heavily reliant on exports of natural resources.

For example, the Canadian economy is closely linked to oil prices, so the CAD/USD pair tends to have a positive correlation with oil prices.

Risk Appetite and Safe-Haven Correlations

During times of market uncertainty or volatility, investors often shift their capital from riskier assets to safer assets, which can create correlations between currency pairs.

The Japanese Yen (JPY), Swiss Franc (CHF), and US Dollar (USD) are considered safe-haven currencies, as they tend to attract capital during times of market stress.

Conversely, currencies like the Australian Dollar, New Zealand Dollar, and South African Rand (ZAR) are often seen as riskier assets and may exhibit negative correlations with safe-haven currencies during periods of market turbulence.

This is because they are often dependent on commodity exports, which are pro-cyclical, or because they have higher degrees of credit risk (e.g., EM currencies).

Interest Rate Correlations

Central banks’ monetary policies, particularly interest rates, can have a significant impact on forex correlations.

When a central bank raises interest rates, the currency typically strengthens, attracting foreign capital and increasing demand.

Conversely, when a central bank lowers interest rates, the currency may weaken.

For example, if the European Central Bank (ECB) raises interest rates more than discounted by markets while the US Federal Reserve keeps rates steady, the EUR/USD currency pair may experience upward pressure.

Inflation and Economic Growth Correlations

Currency pairs may also exhibit correlations based on the economic performance of their respective countries.

Inflation and economic growth are two key indicators that can influence a currency’s value (as well as any asset class).

For example, if inflation in the United States rises faster than in the Eurozone, the USD may weaken against the EUR, resulting in a potential increase in the value of the EUR/USD currency pair.

Political Correlations

Political events and changes in government policies can create correlations between currency pairs.

Elections, referendums, and geopolitical tensions can lead to market uncertainty and currency volatility.

For example, Brexit led to significant fluctuations in the GBP/USD and EUR/GBP currency pairs, as investors were uncertain about the future relationship between the UK and the EU.

Time Frame Considerations

Forex correlations can vary depending on the time frame being analyzed.

Short-term correlations can be influenced by market events or news, while long-term correlations are more likely to be driven by fundamental economic factors.

Traders should consider both short-term and long-term correlations when developing their trading strategies.

Intermarket Correlations

Forex correlations can also be influenced by relationships with other financial markets, such as equities, bonds, and commodities.

For instance, a strong stock market performance may boost investors’ risk appetite, leading to a sell-off in safe-haven currencies and an increase in demand for riskier currencies.

Similarly, rising bond yields can attract foreign capital and influence currency valuations.

Currency Index Correlations

Another way to analyze forex correlations is by examining the relationship between currency pairs and their respective currency indices.

Currency indices, such as the US Dollar Index (DXY) or the Euro Index (EXY), can provide valuable insights into the overall strength or weakness of a currency, which can subsequently impact its correlations with other currency pairs.

Diversification and Portfolio Management

Understanding forex correlations is essential for managing risk in a trading portfolio.

Highly correlated currency pairs can lead to a concentration of risk, as they often move in the same direction.

By incorporating negatively correlated or uncorrelated currency pairs into a trading portfolio, traders can diversify their risk and potentially enhance their returns.

Changing Correlations

As mentioned, FX correlations are not static and can change over time due to shifts in economic conditions, market sentiment, and geopolitical events.

Traders should regularly monitor and update their correlation analysis to ensure their strategies remain relevant and effective.

Tools for Analyzing Forex Correlations

Several tools and resources are available to assist traders in analyzing forex correlations.

Online platforms and charting software typically offer correlation matrices, which display the correlation coefficients between various currency pairs over a specified time frame.

This information can help traders identify potential opportunities and manage risk more effectively.

Conclusion

An analysis of forex correlations requires a comprehensive understanding of the numerous factors that influence the relationships between currency pairs.

By considering aspects such as currency relationships, commodity prices, risk appetite, interest rates, inflation, economic growth, political events, intermarket relationships, currency indices, diversification, and changing correlations, traders can develop a robust understanding of the forex market’s interconnected dynamics.

This knowledge can then be applied to enhance trading strategies and improve overall performance.

Understanding forex correlations can be a valuable tool for traders to manage risk, diversify their portfolios, and develop more sophisticated trading strategies.

By keeping an eye on the factors that affect these correlations and being aware of how they evolve over time, traders can make better-informed decisions and improve their overall trading performance.