Correlations in the Forex Market

As with any financial market, the Forex market often has correlations with other financial markets. A correlation exists in the Forex market when a currency pair moves in price in relation to the price movements of a commodity, security or other financial instrument in a separate financial market. The Forex market also has tendencies to correlate in relation to the attitude to risk of investors in the financial markets as a whole. Correlations can be either positive correlations (which means when one market moves, the other market moves in the same direction) or negative correlations (which means when one market moves, the other market moves in the opposite direction).

There are a number of correlations that exist in the Forex market, and they can occur for a variety of reasons. As you spend more time studying the Forex market and gaining experience as a trader, you will begin to notice these correlations and when they occur. It is useful to start with an understanding of the basic concept and this article looks at some of better known correlations in the Forex market.

Correlation to Gold

Gold was once a global currency in its own right and has a played a role in the currency markets in one form or throughout history. Although no longer used, the gold standard was used to measure the value of currencies in relation to the precious metal. To this day, gold is a popular form of investment and is regularly traded across the world. Changes in the price of gold tend to impact the value of currencies in different ways.

For example, the US dollar has a negative correlation with gold. Generally speaking, when investors are buying gold it is because they are moving away from investing in currencies. The US dollar (USD) is the most traded currency in the world so it is somewhat logical that this is the currency most affected. If gold is rising in price, then you would expect to see the US dollar falling in value against the majority of other currencies. Conversely, when gold is falling in price the US dollar will usually be increasing in value.

The Swiss franc (CHF) on the other hand has a positive correlation with gold. This is for a variety of reasons, primarily due to the fact that the Swiss franc shares some traits with gold – such as being largely neutral to global conflicts. When the price of gold is rising, most of the time you would expect the value of the Swiss franc to rise too. Therefore the USD/CHF currency pair has a negative correlation with gold. Rising prices in gold would tend to mean a fall in the price of the USD/CHF pair, and vice versa.

Correlation to Oil

Oil is used for transporting goods around the world, for fuelling our cars and creating power among other things. It is one of the most important products in the world and is vital in terms of economic production. In one way or another, virtually all services and products use oil. It is not surprising, therefore, that the price of oil can have a significant effect on the value of global currencies.

The production and usage levels of oil in a country will affect the way their currency correlates to oil. A country that produces more oil than it uses and exports the surplus will see its currency have a positive correlation with the price of oil. If a country imports the majority of its oil then its currency will have a negative correlation with the price of oil.

Take Canada for example, a country that has oil as one of its largest exports. They use less oil than they produce, meaning they have a surplus to sell to other countries around the world. Firstly, rising oil prices is good for Canada as it means a higher value on their exports which leads to their economy strengthening. As oil is sold around the world in US dollars, Canadian oil companies receive US dollars for their oil and then sell those US dollars for Canadian dollars (CAD). This leads to the Canadian dollar strengthening against the US dollar – so the Canadian dollar has a positive correlation with oil. If the price of oil should fall, then the Canadian economy would weaken and the value of the Canadian dollar would fall.

Now consider the United States – a huge consumer of oil because of the size of the country and its economy and, to an extent, the use of cars in the country. The US imports a lot of oil, so a rise in the price of oil has a negative impact on the American economy as it has to send more US dollars overseas to pay for the product. The US dollar is negatively correlated to the price of oil. When the price of oil is rising, the US dollar is falling and when the price of oil is falling, the US dollar is rising.

Correlation to Risk

Many currencies in the world have a correlation to the actions of investors and, specifically, their attitudes to risk. When there is a lot of confidence in the financial markets in general, investors will tend to move their investments into developing nations where there is the chance of higher yields. This tends to see major currencies, particularly the US dollar, weaken somewhat against the currencies of nations with smaller economies. When there is more fear in the markets, investors tend to look for safer places for their capital and are more likely to favour the major currencies.

The US dollar is essentially an anti-risk currency. When there is a lack of confidence in the global markets, investors see the US dollar as a relative safe haven. The United States has one of the largest economies in the world, political stability and high levels of reserve currency, and there is plenty of liquidity. It stands to reason that in times of uncertainty, the US dollar is considered the safe option and as such is likely to increase in value during such periods. The same is true, but to a lesser extent, for other major currencies in the world.

Summary

Like any form of indicator that can be used to trade forex, currency correlations should never be considered as guaranteed to perform as expected. However, there is no doubt that correlations do exist in the Forex market in relation to other markets and they can definitely create trading opportunities. Understanding the various correlations and how they can affect the value of currencies can be very useful in identifying profitable trades.