How do currencies move in relation to each other?

In order to be an effective trader, it is important to understand how different currency pairs move in relation to each other. There are a few reasons why this is significant, but most importantly, it allows traders to understand their exposure.

As we have stated time and again, correlations between different currency pairs will inevitably shift over time. Therefore, it is of utmost importance to keep abreast of these fluctuating relationships to fully understand your trades and portfolio.

Below are the one-, three-, six- and twelve-month correlations for the seven major currency pairs. Additionally, we have included the six-month trailing correlation for the majors against the EURUSD for a different view of correlation.

In order to be an effective trader, it is important to understand how different currency pairs move in relation to each other.

There are a few reasons why this is significant, but most importantly, it allows traders to understand their exposure. For example, having a portfolio that consists of the NZDUSD and AUDUSD is different than having a portfolio comprised of NZDUSD and USDCAD.

As can be seen in the tables below, the pronounced and absolute rally in the dollar and sharp drop in commodity-dependent economies’ growth forecasts have strengthened the correlation (0.94) between AUDUSD and NZDUSD. For the same reason, the NZDUSD and USDCAD pairs have a very highly negative correlation (-0.82) that exists because the exchange rates are denominated on the opposite side of the dollar.

From a trading perspective, this means that having long exposure in both NZDUSD and USDCAD would generally negate profit or loss because when NZDUSD rallies, USDCAD will sell off the majority of the time. Of course, these two currencies may have different pip values and the correlation is not perfect, so the P/L will not be exactly zero.

Alternatively, holding long NZDUSD and AUDUSD positions would be akin to nearly doubling up in one of the pairs since the correlation is so strong. Furthermore, we can tell from our tables that correlations shift with time.

In the past month, demand for a safe haven has led the market to liquidity over the typical unwinding of the carry trade. As panic took over for normal market operations, the relationship between the consistently positively correlated USDJPY and USDCHF went to near zero (0.05) as traders sought an absolute level of safety.

Looking back over the year though, the relationship was much stronger (0.53). Even this yearly reading has been skewed by recent market activity. Shifts such as these occur often and can be partially explained by changes in the severity of monetary policy or changes in market conditions. Overall, having this knowledge will allow traders to effectively diversify and manage their portfolios.

Regardless of your trading strategy and whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to keep in mind the correlation between various currency pairs and their shifting trends.

FX Correlations (data as of 11/03/08)

John Kicklighter, Currency Strategist, FXCM (DailyFX.com)