Correlations prove a useful guide in trading the FX market

MIXED macroeconomic data over recent weeks has seen investors&rsquo; risk appetite rise and fall on an almost daily basis, making it difficult for foreign exchange traders to take anything other than a very near-term view on a currency pair. <br /><br />If you&rsquo;re not a short-term trader looking to jump in and out of the market, then your trade is likely to be based on a fundamental view. But with risk appetite see-sawing, it can be hard to discern trends in the madness of the market. <br /><br />However, correlations between currencies and other asset classes such as equities or specific commodities can provide some guide and direction to your trading decisions, although you would be foolish to use them exclusively.<br /><br />A correlation measures how closely two assets&rsquo; values change relative to each other, scoring +1.00 if they move perfectly in line and -1.00 if they always move in the opposite direction. A coefficient of zero means that there is no correlation at all.<br /><br />With earnings top of the agenda at the moment, forex traders would do well to look at currencies that are correlated with equities, such as the Japanese yen and the US dollar, which, on the whole, move inversely with global equities. <br /><br />And in emerging markets such as Poland and the Czech Republic, currencies are highly correlated with the stock index, says George Tchetvertakov, head of market research at Alpari UK. &ldquo;If you are trading the Polish zloty or the Czech koruna, you are almost trading the stock market directly,&rdquo; he adds.<br /><br /><strong>COMMODITY CORRELATION</strong><br />Beyond the equity markets, the correlation between commodities and certain currencies is well-known. Large exporters of a particular commodity will tend to see their currency and the commodity price move in line. <br /><br />For example, you will often see a connection between the South African rand and gold or the Norwegian krone and oil. The Australian dollar, the New Zealand dollar and the Canadian dollar are typical commodity currencies and will do well out of the current increase in demand for raw materials and energy.<br /><br />Strategists at Bank of America-Merrill Lynch say that &ldquo;the recent bout of position liquidation has reinforced an already strong and steady G10 FX correlation with oil, with a noticeable increase in short-term correlations&rdquo;.<br /><br />For example, their research shows that the rolling 25-day correlation between Australian dollar-US dollar and West Texas Intermediate crude oil has risen to +0.75 from +0.3 over the past couple of weeks. The relationship between the Kiwi-US dollar and crude is 0.46.<br /><br />The rolling 100-day correlations between oil and both the Aussie dollar-US dollar and the Kiwi-US dollar are nearly +1, showing how closely they move in line.<br /><br /><strong>DOLLAR CONFIDENCE</strong><br />Another particularly evident correlation is the inverse relationship between the US dollar-Japanese yen and the yield on the 10-year US Treasury. Rising US Treasury yields and yen strength indicate a lack of dollar confidence because investors need a higher return to remain interested. <br /><br />However, when using correlations between currencies and other assets as part of your trading decisions, you need to be aware that correlations can come in and out of focus. What holds true today may not do so in a month&rsquo;s time, as the charts on the right show. <br /><br />&ldquo;Correlations can disengage quickly so I would use them more as an indicator of capital flows rather than as a trading signal,&rdquo; says Tchetvertakov.<br /><br />Correlations should always be used in context but they are useful for making sense of the apparent chaos of the currency markets.