Be Careful! Currency Correlations Change!

Think currency relationships are permanent? Think again!

The fascinating truth is, that they’re constantly shifting.

Let’s dive into the “why” behind these ever-changing currency correlations.

The forex market is like a schizophrenic patient suffering from bipolar disorder who constantly eats chocolates, experiences extreme sugar highs, and has volatile mood swings all day long.

We’re not even exaggerating.

Although currency correlations between currency pairs can be strong or weak for days, weeks, months, or even years, they do eventually change and can change when you least expect it.

The strong currency correlations you see this month may be totally different next month.

[Have a look at the table below.

Compare the coefficients for a given pair across the different time frames.

Do you notice anything?

For the most part (thanks, USD/JPY!), they’re different across the board, changing from one time frame to another. And they change in all directions.

The lesson here is that currency correlations do change, and they change frequently.

And they can change by a drastic measure in a short time frame, as is apparent by looking at EUR/USD at the 1-month and 3-month intervals.

That’s a big swing!

Because of the constant sentiment shifts in the currency market, make sure you’re aware of the current currency correlations.

For example, over a one-week period, the correlation between USD/JPY and USD/CHF was 0.22. This is a very low correlation coefficient and would indicate that the pairs have an insignificant correlation.

However, if we look at the three-month data for the same time period, the number increases to 0.52 then to 0.78 for six months, and finally to 0.74 for a year.

In this example, you can see that these two pairs had a “break-up” in their long-term correlation relationship. What was once a strongly positive association in the past has extremely weakened in the short term.

If they were a real couple and had only dated a month or less, they would’ve thought they were incompatible.

Little do they know, the passion will start heating up later!

If you look at EUR/USD and GBP/USD, here’s an example of the extent to which currency correlations can change and jump around.

The one-week period shows a very strong correlation with a 0.94 coefficient!

But this relationship severely deteriorates in the one-month period, dropping to 0.13, before improving again for its three-month period to a solid 0.83, then deteriorating again to a weak correlation in its six-month trailing period.

Here’s a crazy example of how dramatic currency correlations can change.

Let’s take a look at USD/JPY and NZD/USD…

Their one-year correlation coefficient was -0.69.

This indicates a moderate to strong correlation.

But if you look at their one-month correlation, the correlation coefficient essentially flip-flopped!

So be careful.

What factors cause currency correlations to change?

Currency correlations are not static and can change due to various factors:

Economic Factors

Interest Rate Differentials: Changes in interest rates between two countries can significantly impact their currency correlation. Higher interest rates typically attract foreign investment, strengthening the currency and potentially altering its correlation with others.

Economic Growth: Differences in economic growth rates can also lead to shifts in currency correlations. A country with robust growth will likely see its currency appreciate, potentially changing its relationship with other currencies.

Trade Flows: Trade balances and terms of trade can impact a country’s currency and its correlation with its trading partners

Geopolitical Events

Political Instability: Political events such as elections, conflicts, or policy changes can create uncertainty, leading to shifts in currency correlations as market participants seek safe-haven currencies.

Global Events: Major global events like pandemics, natural disasters, or geopolitical tensions can cause significant market volatility and changes in currency correlations.

Market Sentiment

Risk Appetite: Market sentiment and risk appetite play a crucial role in driving currency movements. During periods of risk aversion, investors tend to flock to safe-haven currencies, impacting their correlations with riskier currencies.

Speculation: Speculation and market sentiment can also cause short-term fluctuations in currency correlations.

Technical Factors

Technical Levels: Breakouts or breakdowns of key technical levels (support, resistance, trend lines) can signal changes in trend and potentially impact currency correlations.

Chart Patterns: The emergence of specific chart patterns can also suggest shifts in currency relationships.

Timeframe

The timeframe under consideration can also affect the perceived correlation between currency pairs.

Short-term: Short-term correlations can be influenced by temporary factors like news events or market sentiment.

Long-term: Long-term correlations are typically more driven by fundamental economic factors and tend to be more stable.

The Importance of Staying Vigilant

The dynamic nature of currency correlations highlights the importance of staying informed and adapting trading strategies accordingly.

You should regularly monitor economic indicators, geopolitical events, market sentiment, and technical factors to identify potential shifts in correlations.

By understanding these changes, you can better manage risk and capitalize on new opportunities in the ever-evolving forex market.

In conclusion, currency correlations are not set in stone! It is not a sword. (Get it?)

These can include anything from a country changing interest rates, to shifting monetary policies, or any collection of economic or political events reshaping traders’ sentiment on a currency.

They are constantly shifting in response to a variety of factors.

Use our Currency Correlation Calculator to stay updated with current currency pair correlations.