The correlation between currency pairs
The correlation between currency pairs is important to know as it can help to make informed decisions in your day to day trading.
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.
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 possible 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.
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.