When Currency Correlation Breaks Down
Correlations Are A Two Edged Sword
Currency correlation is a big deal in the forex world. It defines the way in which currency pairs move in relation to each other. On one hand there are pairs which share a currency like EUR/USD and USD/JPY and on the other individual currencies which tend to move in tandem with each other like the yen and the Swiss Franc. Regardless the type of correlation the unifying idea is that they provide trading opportunities. If one pair is going up then another pair should go up/down depending on the correlation.
If two pairs share the same denominator or numerator those pairs will tend to move in the same direction. If two pairs share a currency but it is the denominator in one pair and the numerator in the other pair those pairs will tend to move in opposite directions.
Over the past few years there has been a clear correlation between the dollar and the euro and the yen. Where the FOMC was actively tightening policy in support of the dollar the other two central banks were engaged in easy money policy, QE and actively weakening the euro and yen. This meant that, on a day to day basis, news that would strengthen the dollar would weaken the other two causing them to move in tandem. Because the USD denominates the EUR/USD pair and numerates the USD/JPY pair these pairs move in opposite directions. Savvy traders could use a single economic, fundamental or news driven signal to make 2 separate and distinct trades.
The risk facing traders then was the chance of over-exposing themselves to the market. Yes, the EUR/USD and USD/JPY are two different forex pairs and offer a basic level of diversification but because they were so closely correlated trading on one was as good as trading on the other. The risk now is that the old correlations are breaking down, have broken down, putting the traders relying on them in danger of unanticipated and unnecessary losses.
Then. In the old days, that is the past few years, FOMC policy was hawkish while ECB and BOJ policy have been very dovish. This created a divergence in policy which drove a wedge between the dollar and each of the other currencies. In recent months FOMC outlook has softened somewhat while ECB outlook has turned a bit hawkish and BOJ outlook remains the same. This has left the FOMC and the BOJ in divergence, but is bringing the ECB into convergence with the US central bank. Now, news in support of a stronger dollar will still boost it versus the yen but strengthening sentiment toward the euro is sandbagging that pair.
So, what is a trader to do? The first thing is to be aware of correlations. They are an important part of the forex trading experience and crucial to your success. The next thing to do is be aware of the underlying fundamental causes for correlations. Is it because policies are divergent or convergent. After that you need to watch for when these factors begin to change because that is when your correlations will break down. In terms of the euro, the yen and the dollar…. these pairs are still expected to move and will be driven by US data and data from the respective countries. What they won’t do is move in tandem with each other the way they once did.