What is Currency Correlation?

06/08/2020

One of the things which any new visitor can notice in many Forex news website posts is the term ‘currency correlation’. Many analysts and experienced traders are using this term and try to utilize this as another tool for making accurate predictions. So, What is the definition of currency correlation?
 
Basically, the essence of positive correlation is when two different securities tend to move in the same direction. For example, Canada is a major oil producer. The local economy can certainly benefit if the price of this commodity increases. Even without using an advanced Forex currency correlation calculator, one can suspect that the Canadian dollar and the price of oil are closely connected.
 
The market knows this well, so in most cases when Oil becomes more expensive, USD/CAD and EUR/CAD falls and CAD/JPY rises. This is why we can say with some confidence, that CAD/JPY is positively correlated with Oil.
 
There is also a negative correlation when two securities move in the opposite direction. So USD/CAD, EUR/CAD, and Oil would be such examples.
 
Another case of this phenomenon would be the relationship between the American Dollar and Gold. During the height of USD strength from 1996 to 2001, the price of the latter fell significantly, from $400 to as low as $260. During the subsequent years of USD weakness, the price of Gold tripled and reached all-time high levels.
 
Traders can utilize currency correlation factors for making better trading decisions. However, at the same time, it is useful to keep in mind that this may not always guarantee success.

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Understanding Currency Correlation

In order to get a better idea about what does the currency correlation mean and the mechanics of this subject, let us take a look at this Forex pairs correlation table:
Understanding currency correlation
The correlation is measured by a coefficient, which can range from -1 to +1. For example, 1.00 means that two currency pairs move exactly the same way. The opposite is true for -1.00.
 
The basic explanation is that:
 
  • Coefficients range from -1 to +1
  • +1 or 1.00 means that currencies are identical in a way how they move
  • -1 or -1.00 means that currencies move completely the opposite way
 
The table itself shows the correlation coefficient, using hourly movements for the last 300 trading hours. Simply taking and analyzing data for only one day can be misleading, since some particular events might disrupt the market. However, using such a larger sample could be much more useful.
 
Nowadays traders do not have to necessarily know how to calculate currency correlation. Many trading platforms and Forex news websites provide this type of information. For example, this Forex correlation table was constructed, using the numbers from the Forex correlation calculator at investing.com.
 
So what is the meaning of currency correlation data? How can we interpret this?
 
As we can see here, for example, the coefficient for EUR/USD and GBP/USD is 0.94. This suggests that those two pairs very often move in tandem. In fact, they are not very far from almost a perfect correlation.
 
On the other hand, the coefficient for USD/CAD and Gold is -0.67. In this case, those two securities often move in opposite directions.
 
Not all of the securities are closely connected to each other. For example, on the table, the combination USD/JPY and Gold shows -0.45. This does suggest that there is some negative correlation, but it is relatively weak, so it might not be advisable to make trading decisions, based on their relationship. Many traders are looking for pairs with a minimum of 0.6/-0.6 coefficient in their analysis.


How some traders magnify their risk exposure without knowing it

We know that most of the experts and experienced traders advise us not to risk more than 5% of trading capital on a single trade. This makes sense, however considering the things we discussed above, it seems traders might take on more risk than they realize.
In order to get a better understanding of the currency correlation meaning, it can be helpful to turn to some practical examples.
 
Let us suppose that the trader has $10,000 on a trading account. He or she takes the advice of professionals in the field and only risks $500 (5% of the Funds) in every single trade. So the trader has opened long EUR/USD, GBP/USD, and short USD/JPY positions.
 
If one has no idea what a currency correlation is, then at first glance, this might seem like a well-diversified trading portfolio, with reasonable risk management. However, this line of reasoning ignores the dynamics of currency correlation. As mentioned before the coefficient for EUR/USD and GBP/USD is 0.94, at the same time both of those pairs USD/JPY have a very strong negative correlation between -0.87 and -0.92.
 
Essentially those three positions very often move towards the same direction. So instead of only risking 5% of the funds, in real terms, the trader risks 15% of the account and if things go wrong, the losses can be considerable. This is something to keep in mind, before opening several positions.
 
Positively correlated pairs can also be utilized in a different way. For example, a day trader might be looking for an opportunity to open a position with the AUD/USD pair. However, the economic data might be contradictory and there are no clear technical indicators. So it is very uncertain in which direction the market will go.
 
In this case, he or she can take a look at the latest correlation data and take a look at those currency pairs and commodities, which have a high coefficient with AUD/USD. Therefore, looking at GBP/USD or Gold price might be more informative during this process of decision making.


How can negatively correlated pairs be used for trading?

The currency pairs with negative correlation can be just as useful as the examples mentioned above. In fact, sometimes they can be utilized as some sort of insurance policy against the potential losses.
 
How is this possible? Well, let us return to our previous example. Suppose, that because of the rising Gold price, the trader decides to open a long AUD/USD. In order to hedge against the risk, it is possible to open a long position with the pair with a very strong negative correlation, for example, USD/JPY. Since those two pairs mostly move in opposite directions, then the loss in one case can be compensated by profits from the second trade.
 
Now there is an obvious question: what sense does this make? Those two positions will cancel each other out and the trader will end up with zero profit. Is this not the most likely outcome?
 
Well, not necessarily, the trader is not obligated to close those two trades at the same time. Let us say that after placing those trades, AUD/USD fell by 0.5% and USD/JPY has risen by the same percentage. If the direction of the market is clear, the trader can close losing the AUD/USD position, while keeping USD/JPY open.
 
In the worst-case scenario, if suddenly the market changes direction, the long USD/JPY position can be liquidated to offset some of the earlier losses. On the other hand, if the pair keeps rising and ends up appreciating, say by 0.7% or even 1%, then the trader can close this position and make a nice profit.
 
Obviously, none of those strategies can have a 100% success rate, but this can work in many cases.


Exceptions to the rule

As we can see in most cases the correlation coefficient measure of different currencies can be very helpful in identifying potential trends. However, just like with every other rule, here also are some exceptions.
 
Australia is a major producer of Gold, therefore it is not surprising that AUD/USD and XAU/USD have a notable connection. In fact, in the table above the Forex currency correlation indicator shows 0.76, which is significant.
 
So how can the Australian dollar fall, even in times of rising Gold prices? Or how does the AUD appreciate during a time when precious metals are becoming cheaper?
 
Actually, there can be several scenarios of that nature. For example, because of fears of recession, the demand for Gold might increase and push the price higher. While in the meantime, because of the same concerns the Reserve Bank of Australia, might decide to cut the cash rate to stimulate the economy. As a result, the investors and traders might be less attracted to the lower-yielding Australian dollar and AUD/USD might fall significantly.
 
It does not even have to do with the Reserve Bank of Australia. All currency pairs have two parts of the equation. It might happen, for example, that the Gold price starts to fall and at the same time the 10 year US treasury yields decline significantly In this scenario USD might lose the traction and AUD/USD could rise, despite the precious metals losing ground.
 
Therefore the currency correlation observations must be combined with the fundamental analysis since such factors as monetary policy decisions, geopolitical events, and even regular economic data releases can easily disrupt the normal behavior of currency pairs.
 
One example of this might be the performance of the British Pound during and after the 2016 EU referendum. We have already discussed that EUR/USD and GBP/USD have a very high correlation coefficient. As a result, those two European currencies do not move much against each other and EUR/GBP is much less volatile than most of the other pairs. So in this case, a 1% change in a day can be noticeable.
 
As the referendum results started coming in and after some hours it became apparent that the ‘remain’ side lost the campaign, the pound started free falling. The British currency lost 10% against USD and even traditionally less volatile EUR/GBP has risen by more than 7% in a single day.
 
This is just another example, confirming the savvy trader should not always trust the past market patterns during the decision making.
 
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Forex Currency Correlation - Key Takeaways

  • The Forex correlation indicator can be a helpful tool when looking for trading opportunities. However, this does not necessarily mean that the correlated securities will always move in the same direction. Major economic announcements, Central Bank Policy decisions, and other events can disturb the usual market patterns.
 
  • Not all currencies and commodities are correlated with each other to the same extent. For example, two Forex correlation pairs with 0.80 score is much more significant, than the ones with 0.60 or 0.40.
 
  • Using currency correlation analysis can help traders with their risk management. Hedging is one of the methods to reduce exposure. For example, traders can open positions with two negatively correlated currencies in an effort to reduce risk. While this strategy does not always guarantee success, it can be still helpful for many traders.
Using currency correlations to your advantage

FAQ: Using currency correlations to your advantage

How can the hedging strategies help with trading profit margins?

When it comes to earning money in Forex trading, the actual amounts of profits and losses matter even more than simply the number of winning and losing trades. For a single trading day, a trader might succeed with 3-4 positions, but without proper risk management, one devastating loss can wipe out all of the gains. This is one of the reasons why many people lose money in trading.
 
Hedging strategies can help to mitigate potential losses. Essentially, what it does, is to limit the potential downside with one losing position and give an opportunity to the trader to exploit the winning trade.
 
This hedging strategy does not always include opening exactly an equal number of positions on the opposite side of currency pair correlation mechanics. For example, a trader might open long AUD/USD and GBP/USD positions, but at the same time as some sort of insurance policy decide to place a trade, shorting Gold.
 
Even if the trader loses money on the first two cases, then at least that trade on precious metal can cover some of those losses.


Which currencies are most correlated with the price of Oil?

As mentioned before, CAD currency pairs have a significant correlation with Oil prices. Because of very large Oil production, the Russian Ruble is also tied to this commodity. However, analyzing the Forex currency correlation chart can show that the RUB is not as strongly correlated with Oil as in the case of CAD.
 
That seems strange, considering that half of state budget revenues in Russia come from the energy sector. For several decades now, the entire economy of this country has been heavily dependent on this commodity.
 
The problem here is that Ruble has a history of high inflation, in most of the previous years, CPI gained as much as 8% on an annual basis. Also, the currency has been hit hard by the US and EU sanctions since 2014.
 
Therefore, most of the investors, who are looking to invest in a currency, which is tied to Oil, would think that CAD seems like a safer option, than RUB. The Canadian currency has a history of stable, low inflation and also the highly effective Central Bank. Consequently, in most cases in the rising energy prices environment, CAD can gain more than RUB.


Why do some investors prefer to invest in AUD securities, instead of buying physical gold?

There are many financial experts, who advocate for investments in Gold, Peter Schiff and Axel Merk are just two examples.
 
However, as Dave Ramsey points out, the downside with this type of asset class is that it does not pay any interest and is very volatile.
 
There are some investors, interested in profiting from the rising Gold prices, but at the same time are looking to earn an income. Investing in Australian government bonds and dividend-paying stocks can be one way to achieve that.
 

Why are AUD and CAD called ‘Commodity Currencies’?

Some experienced traders divide the Forex market into two camps: Commodity currencies and Consumer-based currencies. For example, CAD has an Oil-producing Economy, AUD is tied to Gold production. At the same time, USD and JPY are negatively correlated with the price of those commodities.
 Currency correlation explained 
In a way, traders and investors can use AUD and CAD as proxies for entering Gold and Oil trades. In fact, those currencies are less volatile, than the above-mentioned commodities themselves.
 

Is NZD correlated with commodity prices?

Like AUD and CAD, NZD is also considered a commodity currency. New Zealand is one of the world’s largest producers of dairy products, such as cheese, butter, and milk. In fact, they make up more than 20% of the country’s exports. Consequently, when prices for those food items increase, the NZD can benefit from that and appreciate against other currencies.
 
New Zealand also has a stable economy with a reputable Central Bank. In fact, they were the first financial institutions to introduce inflation targeting. It eventually paid off with the latest figures pointing at only a 1.9% CPI increase during the last 12 months.
 

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