Currency Correlations

Currency pairs do not move independently. Because many pairs share a currency, especially the US dollar, and because economies are linked by trade and risk sentiment, pairs often move together or in opposite directions. A trader who buys EUR/USD and GBP/USD at the same time may think they have two trades, but they often have one large bet against the dollar. Understanding correlations helps traders manage total risk, avoid accidental concentration and find related opportunities. The statistics are covered in Covariance and Correlation.

Correlation basics#

Correlation ranges from minus 1 to +1:

• +1: pairs move in the same direction in lockstep.
• 0: no consistent relationship.
• minus 1: pairs move in opposite directions in lockstep.

Correlations are calculated on returns over a window, such as daily returns over 60 or 120 days, and they change over time.

Common relationships#

Correlations are typical patterns, not rules; they can weaken or flip.

Risk on and risk off#

• Risk on: investors buy higher yielding and growth linked currencies (AUD, NZD, emerging markets) and sell safe havens.
• Risk off: investors buy safe havens, traditionally the US dollar, Japanese yen and Swiss franc, and sell riskier currencies.

During sharp market stress, correlations across risky assets tend to rise, so diversification across "different" risk currencies can disappear when it is needed most. See Correlation Management.

Avoiding hidden concentration#

Using correlations in trading#

• Confirmation: a move in EUR/USD that is not matched by GBP/USD or the dollar index may be pair specific.
• Hedging: a long EUR/USD can be partly hedged with long USD/CHF, though the hedge is imperfect.
• Relative value: trading a cross such as EUR/GBP isolates the euro versus the pound, removing the dollar. See Currency Pairs: Majors, Minors and Exotics.
• Divergence trades: when normally correlated pairs drift apart, some traders bet on convergence, a form of Pairs Trading.

The dollar index#

The US Dollar Index (DXY) measures the dollar against six currencies, with the euro making up about 58% of the weight. Because so many pairs include the dollar, DXY is a quick gauge of broad dollar moves. Many pairs show strong correlation with it.

Correlations change#

• Policy shifts: when one central bank moves differently from its neighbours, correlations break.
• Commodity shocks can separate commodity currencies from each other.
• Regime changes in risk sentiment alter safe haven behaviour. See Structural Breaks and Regime Changes.

Recalculate correlations regularly over several windows rather than relying on old figures. See Rolling and Expanding Windows.

Common mistakes#

• Treating correlated pairs as independent trades.
• Assuming correlations are fixed.
• Hedging with a pair whose correlation is weak or unstable.

Frequently asked questions#

What is currency correlation?#

A measure of how closely two currency pairs move together, from minus 1 (opposite) to +1 (same direction).

Which currency pairs are highly correlated?#

EUR/USD and GBP/USD, and AUD/USD and NZD/USD, are usually strongly positive; EUR/USD and USD/CHF are usually strongly negative.

Why do currency correlations matter?#

Because holding several highly correlated positions concentrates risk, so a single move can cause losses on all of them at once.

Next, learn the force behind many currency trends in Interest Rate Differentials.