Have you ever noticed that some currency pairs move in the same direction? For example, the NZD/USD pair often follows the movement of the AUD/USD pair. This phenomenon is called “correlation“.
Currency correlation is a measure of the mutual relationship between two currency pairs. The correlation coefficient is presented in decimal format and ranges from +1.0 to -1.0.
- Positive correlation (+1) means that the two currency pairs move in the same direction 100% of the time.
- Negative correlation (-1) means that the two pairs move in opposite directions 100% of the time.
- No correlation means that the two pairs are not related at all.
Some of the most obvious examples of positively correlated pairs include EUR/USD and GBP/USD, AUD/USD and NZD/USD, USD/CHF and USD/JPY.
Examples of negatively correlated pairs include EUR/USD and USD/CHF, GBP/USD and USD/JPY, USD/CAD and AUD/USD, USD/JPY and AUD/USD.
How to Apply Currency Correlation in Trading?
Understanding currency correlations can help you avoid dangerous mistakes when making trading decisions. Correlation is especially important in medium-term and long-term trading.
For example, it’s important to understand that holding positions in positively correlated pairs increases your potential losses. We know that EUR/USD and GBP/USD typically have a strong positive correlation. This means that buying both EUR/USD and GBP/USD effectively doubles your risk. If your expectations don’t materialize and the euro weakens against the U.S. dollar, the British pound is likely to follow.
A similar situation occurs when taking opposite positions in two pairs with negative correlation (e.g., buying EUR/USD and selling USD/CHF).
Additionally, trading in opposite directions on two correlated pairs doesn’t make much sense—your position is essentially neutral. For instance, buying EUR/USD and selling GBP/USD at the same time is counterproductive. Any market movement will increase your profit on one pair but decrease it on the other. In the end, you might close the trade at a loss due to differences in pip values. The same applies to holding positions in negatively correlated pairs (e.g., buying EUR/USD and USD/CHF).
Trading Tip
Imagine that the EUR/USD pair is testing a key resistance level. Before buying the euro on a breakout, we recommend checking how other dollar pairs are performing at the same time. If the dollar is weakening against most major currencies, you can assume that the current EUR/USD breakout is genuine.
Correlation Between Currencies and Commodity Prices
The foreign exchange market is closely linked to other financial markets. If you trade currencies of commodity-exporting countries, pay attention to factors affecting the price of the country’s main resource and try to form your own forecasts based on them.
Consider the Australian dollar (AUD). Key exports for Australia include iron ore, dairy products, and gold, so the state of the economy and the value of the national currency directly depend on market prices for these goods. The Australian dollar strengthens when these prices rise and weakens when they fall.
As shown in the charts, there is indeed a long-term positive correlation between gold prices and the AUD/USD pair. However, this correlation may weaken in the short term. For example, a sharp sell-off in the U.S. stock market usually weakens the link between AUD/USD and gold.
Another good example of currency and commodity correlation is the Canadian dollar (CAD) and oil. Canada is the largest supplier of oil to the U.S., so when global oil prices rise, it’s worth considering long-term CAD purchases.
Correlation Between Currency Rates and the Stock Market
Correlation Between USD and S&P 500
Generally, a rising stock market is accompanied by a stronger national currency. However, there are exceptions. For example, the correlation between the S&P 500 and the U.S. dollar (USD) is not constant. On one hand, a weak dollar is a positive factor for the U.S. stock market: the competitiveness of American goods on global markets increases, leading to higher company profits and, consequently, stock prices. That’s why the U.S. quantitative easing (QE) program boosted stock indices to record highs. However, numerous local and global factors also influence the dynamics of U.S. stocks. The U.S. dollar and U.S. stock indices are usually reflections of deep economic processes.
In December 2013, the U.S. Federal Reserve announced a gradual exit from the QE program, as well as the possibility of rate hikes in early 2015. There are concerns that tighter monetary policy by the Fed could cause a crash in the stock market, as the amount of cheap liquidity on the market would shrink. Meanwhile, the U.S. dollar may strengthen. Despite this, many economists do not see the winding down of QE and rate hikes as a clearly negative factor. A reduction in monetary stimulus signals that the world’s largest economy is exiting its crisis, which is a positive signal for capital markets. Furthermore, the U.S. authorities are gradually phasing out QE, making decisions based on the dynamics of economic indicators. There is a high probability that in the coming months, a weak positive correlation between the dollar and stock indices will remain.
Correlation Between JPY and Nikkei 225
The Japanese yen and the Nikkei 225 index are another interesting example of changing correlation. Until 20
FAQ
What is currency correlation?
Currency correlation measures the relationship between two currency pairs, ranging from +1.0 (perfect positive correlation) to -1.0 (perfect negative correlation).
How can currency correlation affect trading?
Positive correlation increases risk when holding multiple related positions, while negative correlation can lead to conflicting outcomes if not managed properly.
Can currency pairs correlate with commodities or stocks?
Yes, currencies of commodity-exporting countries often correlate with the prices of their main exports, and some currencies correlate with stock indices like the S&P 500 or Nikkei 225.
