How do currencies move in relation to each other?
The following is our monthly correlations update for
July. As we have mentioned again and again before, correlations between different currency pairs will inevitably shift over time, therefore it is of utmost importance to keep abreast of these
changes. Below are the one-, three-, six- and twelve-month correlations for seven major currency
pairs. Additionally, we have included the six-month trailing correlation versus the EURUSD as further confirmation of the correlation. In order to be an effective trader, it is also 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. That is, having a portfolio that consists of the USDJPY and USDCHF is different than having a portfolio comprised of USDJPY and EURUSD.
As indicated, over the past month, the USDJPY has had a strong positive correlation (+0.93) with the USDCHF and a strongly negative correlation with EURUSD (-0.91). Therefore having a long USDJPY and long EURUSD exposure would generally lead to negated or nearly zero profit or loss because when the USDJPY rallies, EURUSD will sell off the majority of the
time. Of course, these two currencies have different pip values, so the P/L may not be exactly zero. On the other hand, holding long USDJPY and long USDCHF exposures would be similar to doubling up on the position since the correlation is so
strong. Furthermore, we can tell from our tables that correlations shift with
time. For example, the NZDUSD pair has held a fairly negative correlation with the USDJPY (-0.50) over the past three-months
time. Just this last month, however, this relationship has flipped to a more impressive, positive correlation (+0.68). Shifts such as these can be partially explained by changes in the severity of monetary policy or changes in unique domestic
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.