Correlation Between Currency pairs
The mechanism of correlation between currency pairs is important to know as it can help to make informed decisions in your day to day trading. In addition, knowing this topic well allows us to have a clearer image of the forex markets by trading in a more alert and correct manner.
USD ↓ GOLD ↑
Gold ↑ AUD ↑
CAD ↑ Crude OIL ↑
EUR/USD ↓ USD/ CHF ↑
In the forex markets we follow trades on currency pairs or crosses. One is the long part, the purchase, the other is the short part, the sale.
Take for example the pair of Euro/US Dollar (EUR/USD). The Euro is the currency in the first position, also called the base currency or numerator, while the US dollar is known as the variable currency or denominator. The base currency is the one that is most often higher.
When we follow forex market trading, we buy and sell the currency that is in the first position, or the base/numerator. If the US dollar gains strength, the exchange rate drops. If, instead, the dollar weakens, the exchange rate rises.
Currency pairs or crosses can have numerators or denominators in common.
The various forex pairs are correlated among themselves in a mathematical manner, particularly in those pairs that have the base currency or the variable currency in common, so they tend to move in the same way, due to either direct correlation, or the opposite with inverse correlation. Here are some of the more important pairs:
Pair Title Nickname
EUR/USD Euro/US Dollar EUR or Fiber
AUD/USD Australian Dollar/US Dollar Aussie
GBP/USD British Pound/US Dollar Cable
NZD/USD New Zealand Dollar/US Dollar Kiwi
USD/CHF US Dollar/Swiss Frank Chief or Swissy
USD/CAD US Dollar/Canadian Dollar Loonie
USD/JPY US Dollar/Japanese Yen Yen
These 7 currency pairs are the most exchanged in trading and are called the Majors. They all have the US Dollar in common; in some cases in the first position, or base currency and in other cases in the second position, or variable currency.
In the currency markets, the US Dollar is the reference point for all transactions. The importance of the Dollar is so immense that if it did not exist it would not be possibile to exchange the Euro with other currencies, such as the Australian Dollar or the Japanese Yen.
When currency pairs have the same denominator or base currency, they tend to all move in the same direction, making them positively correlated. For example, if the EUR/USD is rising, it is probable that the GBP/USD, AUD/USD or NZD/USD will all move in the same direction. Here is an example of positive correlation:
Furthermore, EUR/USD and GBP/USD have a high correlation in the same way as NZD/USD and AUD/USD have between them. This also has to do with the fact that these sets are affected by macroeconomic events due to being in similar geographical areas.
When, instead, we have two pairs with the same currency in different positions; in one pair as the numerator and the other as the denominator, we then have a negative correlation.
One example is EUR/USD and USD/CHF.
Here is an example of a negative correlation:
If the US Dollar did not exist to equate the Euro and the Australian Dollar, it would not be possibile to have the pair EUR/AUD, as it would not be possible to exchange the Euro with the Australian Dollar. This is why we say that the US Dollar is the basis of the entire forex market, even when it does not appear in the currency pair.
Another important correlation is the one between the stock market and the US Dollar. When US shares are being bought, the dollar tends to rise and strengthen. It is for this reason that when there is risk aversion, the US Dollar tends to rise, because investors prefer to invest in low-risk American assets and this is automatically reflected via the purchase of US Dollars.
Another direct correlation is between a country’s interest rates and their currency. Raising of interest rates tends to push up the value of the country’s currency and of course, the opposite is true when interest rates are lowered.
This is due to two reasons:
High interest rates correspond with an expanding economy
If a high interest rate is applied to a currency, that currency will be bought and be worth possessing for the accumulation of interest.
All traders who find themselves facing the forex arena on a daily basis must therefore have the necessary knowledge to make correct decisions and the correlations, from this point of view, are most useful because they allow us to deduce the movements of the various financial instruments in relation to each other.