Currency pair correlation: How does fx align with other assets?
When it comes to trading forex, currency pairs it may often move in predictable ways with other pairs and may also be positively or negatively aligned to other assets you may already be familiar with. Discover how currency pair correlation works and how you can use fx correlation to inform your own trades.
Looking for something specific? Jump ahead using these links:
- What is currency pair correlation?
- What is the correlation COEFFICIENT?
- What currency PAIRS are correlated?
- Currency correlation with COMMODITIES
- Correlation between currencies and STOCKS
- Currency correlation: TRADING TIPS
What is currency pair correlation?
Currency pair correlation is the measure to which the movement of currency pairs in forex are related to each other but can also describe how forex pairs and markets such as stocks and commodities are linked too. Any relationship between the price of one currency pair with another, or with other markets, can help traders make sense of forex movements and assist them in their decision making.
What is the correlation coefficient?
The correlation coefficient is a measure that represents how strongly or weakly two currency pairs are aligned over a certain time period. It is expressed in values from -1.00 to 1.00, with -1.00 representing the weakest correlation and 1.00 the strongest. For example, if a pair has a currency coefficient of 0.9, that is a strongly correlated pair, while a coefficient of -0.9 will be weakly correlated.
To illustrate, here is a correlation coefficient table for EUR/USD, showing how this major pair relates to three other major currency pairs over various time periods. Notice how GBP/USD shows a positive correlation, but the currencies generally recognized as ‘risk off’ – the Swiss Franc and the Japanese Yen – in this example show a negative one.
EUR/USD correlation with other pairs
Data accrued from June 4, 2020 to June 3, 2021. Source: Yahoo Finance
What currency pairs are correlated?
The key currency pairs that are correlated in the strongest way include pairs such as EUR/USD and GBP/USD, as can be seen above. They often move together due to the economic relationships between the areas they represent.
In this case, GBP and EUR have close ties based on the eurozone and the UK sharing geographical proximity, as well as backup reserve currency status. Also, the fact that both these pairs share the USD as a counter currency mean that any change in the dollar is reflected in both currency pairs simultaneously. See below how the price lines tend to move in similar ways with one another.
Other pairs that tend to show a strong correlation are EUR/USD and AUD/USD and EUR/USD and NZD/USD.
Commodity currency correlation
Currencies can also show an alignment in their movements with certain commodities. For example, the Canadian dollar is linked to oil prices due to Canada’s substantial export trade of the raw material. In practice, this equates to a positive correlation with CAD/JPY, meaning the two move together, and a negative correlation between oil and USD/CAD, meaning when oil goes up USD/CAD tends to go down. This is caused mainly by Canada’s forex earnings as a result of oil sales priced in USD.
When it comes to the relationship between USD and gold, a strengthening dollar relative to other major currencies often means a falling gold price, as can be seen in the image below. Indeed, commodity prices in general tend to see an inverse relationship with USD. Why? Well, as the dollar tends to be the benchmark currency for pricing commodities, a falling USD means it costs more dollars to buy a given amount of commodity and costs a smaller amount of other currencies when USD falls.
Additionally, in risk-off markets, gold retains its value as a safe haven, meaning during such times it’s likely that market speculators shun USD in favor of the precious metal.
Correlation between currencies and stocks
The correlation between currency pairs and the stock market is also a notable phenomenon for those interested in how markets interact – but the relationship can be complex. During risk-on times, traders may go long on certain growth stocks, and temporarily neglect risk-off markets such as gold. But stock market activity can also be influenced by forex considerations too.
For example, in the UK, a falling pound has often resulted in a rising UK FTSE 100 index, and vice versa, as can be seen in the example below. This is because many companies in the index make a large proportion of their profits in US dollars. When these international transactions are converted back into pounds, they are worth more when sterling is weak.
On the US side, there are varying insights on the impact of the strength of USD on stocks. As the US dollar weakens, the revenues generated by export trade are larger when converted back into dollars (the same principle as the example above). Correspondingly, a stronger dollar means US multinationals get less favorable exchange rates when international profits are translated back into USD.
For both USD and GBP, it’s worth remembering that export revenues account for varying proportions of trade from stock to stock. Larger companies naturally do more business outside of the US, meaning a weaker dollar may favor the largest multinationals. Naturally, the flipside is that a weaker dollar means imports are more expensive, so make sure to research company trade patterns for a more tailored feel.
Currency correlation: Trading tips
When devising a currency correlation trading strategy, consider that the diversification of trading two correlated markets may reduce volatility, and improve risk management. This is because while unexpected deviations in price may hit one market in the short term, this may not be the case for a market that is demonstrably correlated with it. Here are some tips for trading correlations:
- Be aware that particular correlations that hold firm ‘on average’ may show periods of weakness. This makes it important to look at both shorter-term and longer-term correlations. A correlation coefficient indicator can be added to a FOREX.com chart to help better understand the relationship between markets.
- When actually placing a trade, consider whether the markets are currently correlated, whether one market leads another, and whether price is diverging. For example, if one market is making lower lows or higher highs and the other is ranging, it may be worth waiting for a period of sustained correlation.
- While trading inversely correlated markets may create scenarios where your trades simply cancel each other out, these trades can also be made for hedging purposes. For example, trading EUR/USD with USD/CHF may not be advisable in the long term, but there may be scenarios where doing so can protect against short-term moves.
- Pairs such as AUD/USD are historically positively correlated with gold. With Australia being a major gold producer, the AUD/USD price may vary depending on Australia’s capacity to export the metal. Therefore, any correlation trader should be well informed on fundamental factors impacting gold production schedules and demand patterns.
Forex Trading Involves Significant Risk of Loss and not suitable for all investors. Past performance is not indicative of future results.