Stephen Nefdt's List: correlations

• Predicting the next move in the markets is the key to making money in trading - but putting this simple concept into action is much harder than it sounds. Professional forex traders have long known that trading currencies requires looking beyond the world of FX. The fact is that currencies are moved by many factors - supply and demand, politics, interest rates, economic growth, and so on. More specifically, since economic growth and exports are directly related to a country's domestic industry, it is natural for some currencies to be heavily correlated with commodity prices. The top three currencies that have the tightest correlations with commodities are the Australian dollar, the Canadian dollar and the New Zealand dollar. Other currencies that are also impacted by commodity prices, but have a weaker correlation, are the Swiss franc and the Japanese yen. Knowing which currency is correlated with what commodity and why can help traders understand and predict certain market movements. Here we look at currencies correlated with oil and gold and show you how you can use this information in your trading.
• In fact, the dollar reacted very differently across various currencies simply because of that particular currency's correlation with commodity prices. Therefore, knowing what type of movement to expect in the Canadian dollar if oil prices drop, for example, will definitely help you make smarter decisions.
• As a net oil exporter, Canada has benefited the most from the rally in oil, while Japan - a major net oil importer - has suffered the most.  
  
• Over the past three years (2003-2005), the correlation between the Canadian dollar and oil prices has been approximately 80%. Canada is the ninth largest producer of crude oil in the world, and it continues to climb up the list, with production in oil sands increasing regularly. In 2000, Canada surpassed Saudi Arabia as the United States' most significant oil supplier. Unbeknownst to many, the size of Canada's oil reserves is second only to those in Saudi Arabia. The geographical proximity between the U.S. and Canada, as well as the growing political uncertainty in the Middle East and South America, makes Canada one of the more desirable places from which the U.S. can import oil.
• In fact, it should come as no surprise that the price of oil actually acts as a leading indicator for the price action in the CAD/USD.
• Oil and the Japanese Economy
  At the other end of the spectrum, Japan imports 99% of its oil (compared to the U.S., which imports 50%). It is one of the world's largest net oil importers. Japan's lack of domestic sources of energy, and its need to import vast amounts of crude oil, natural gas and other energy resources, makes it particularly sensitive to changes in oil prices. Japan also lacks the flexibility to switch to nuclear power because it is a huge net importer of uranium for its nuclear power plants. In 2003, the country's dependence on imports for primary energy stood at more than 79%. Oil provided Japan with 50% of its total energy needs, coal with 17%, nuclear power 14%, natural gas 14%, hydroelectric power 4%, and renewable sources a mere 1.1%. Therefore, when oil prices skyrocket, the Japanese economy suffers.
• An Attractive Oil Play: CAD/JPY
  Looking at this from a net oil exporter/importer perspective, the currency pair that tops the list of currencies to trade to express a view on oil prices is the Canadian dollar against the Japanese yen. In fact, over the past two years, CAD/JPY has had an 85% positive correlation with oil prices. As we can see in Figure 2 below, more often than not, oil prices tend to be the leading indicator (as with USD/CAD) for CAD/JPY price action with a noticeable delay. As oil prices continued to rally, CAD/JPY easily broke the $100 level to hit a high of $105 before reversing. The "Oil vs CAD/JPY" chart also clearly shows the delayed reversal in CAD/JPY - which would have been a perfect trading opportunity.
    
• Going for Gold
  Gold traders may also be surprised to hear that trading the Australian dollar is just like trading gold. As the world's third largest producer of gold, the Australian dollar has an 85% positive correlation with the precious metal. Generally speaking, this means that when gold prices rise, the Australian dollar appreciates as well. The proximity of New Zealand to Australia makes Australia a preferred destination for exporting New Zealand goods. Therefore, the health of New Zealand's economy is closely tied to the health of the Australian economy, which explains why the NZD/USD and the AUD/USD have had a 96% positive correlation over the past three years (2003-2005). Interestingly enough, the NZD/USD actually has an even stronger correlation with gold than the AUD/USD does - the correlation has been 90% over the past three years.
• A weaker, but still important, correlation is that of gold prices and the Swiss franc. The country's political neutrality and the fact that its currency used to be backed by gold have made the franc the currency of choice in times of political uncertainty. From December 2002 until September 2005, USD/CHF and gold prices had an 85% positive correlation
• Trading Currencies as a Supplement to Trading Oil or Gold
  For seasoned commodity traders, it may also be worthwhile to look at trading currencies as an alternative or a supplement to trading commodities. In addition to being able to capitalize on a similar outlook (e.g. higher oil), traders may also be able to earn interest if they are on 2% margin or higher. When trading currencies, you are dealing with countries, and countries have interest rates, of course. For example, in the CAD/JPY trade, a trader who was long CAD/JPY would be able not only to make nice gains, but also to earn up to 3% in interest income. The rough estimate of 3% comes from taking Canada's central bank rate, which is the amount earned, and subtracting the 0% rates paid for shorting the Japanese yen. These are un-leveraged rates, which means that with 10 times leverage, for example, net of any exchange rate changes, the interest income would be that much higher. Leverage also makes the trade riskier, which is certainly something to keep in mind when trading FX.
  
  Along the same lines, if you shorted CAD/JPY to express a short oil view, you would end up paying interest. If you're a commodity trader looking for a bit of a change from the usual pro gold trade (for example), commodity currencies such as the AUD/USD and NZD/USD provide good opportunities worth looking into.
  
  Conclusion
  If you want to trade commodity currencies, the best way to use commodity prices in your trading is to always keep one eye on movements in the oil or gold market and the other eye on the currency market, watching how quickly it responds. Due to the slightly delayed impact of these movements on the currency market, there is generally an opportunity to overlay a broader movement that is happening in the commodity market to that of the currency market. Bottom line, it never hurts to be more informed about commodity prices and how they drive currency movements.
  

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• The correlation between any two variables (or sets of variables) summarizes a relationship, whether or not there is any real-world connection between the two variables. The correlation coefficient will always be between -1 and +1. These two extremes are considered perfect correlations. A negative coefficient means that the two variables, or sets of variables, will move in opposite directions (if one variable increases, the other will decrease); a positive coefficient will mean that the two will move in the same direction (as one increases, the other will increase).
  
  If we compare the US Dollar Index (USDX), an index that tracks the value of the U.S. dollar against six other major currencies, and the value of the Dow Jones Industrial Average (DJIA), Nasdaq and S&P 500 over a 20-year period, the correlation coefficient calculated for the USDX versus the DJIA, Nasdaq and S&P 500, is 0.35, 0.39 and 0.38, respectively. Note that all of the coefficients are positive, which means that as the value of the U.S. dollar increases, so do the stock indexes, but only by a certain amount. Notice also that each coefficient is below 0.4, which means that only about 35% to 40% of the stock indexes' movements are associated with the movement of the U.S. dollar.
  
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  A country’s currency can become more valuable in relation to the rest of the world in two main ways: when the amount of currency units available in the world market place is reduced (for example, when the Fed increases interest rates and causes a reduction in spending), or by an increase in the demand for that particular currency. The fact that an increase in the U.S. dollar affects the value of American stocks seems natural, as U.S. dollars are needed to purchase stocks. The value of American stocks, especially those that are included in market indexes, tend to increase along with the demand for U.S. dollars - in other words, they are positively correlated. One possible explanation for this relationship is foreign investment. As more and more investors put their money in U.S. equities, they are required to first buy U.S. dollars, which can be used to purchase American stocks, causing the indexes to increase in value.  For more insight, see Commodity Prices And Currency Movements and Using Currency Correlations To Your Advantage.

• Think currency rates have nothing to do with stocks? Think again. They are actually quite close relatives, especially the relationship Nasdaq or Dow Jones and the US Dollars, Yen as well as Yen crosses. If you follow daily foreign exchange news, you will notice phrases such as "Yen and Dollar retreat as stock market rise" or "Yen crosses got hammered as stocks plunged." As a matter of fact, professional traders already accept this phenomenon as an indisputable fact that they don't see the need to mention it in the news.
• The nature of forex market, however, is a little more sophisticated. When you deal with foreign exchange, it's always involved at least two different economies (or countries), not only one as in stock market. So the exchange rates are affected by both economies involved (in each currency pair). For example, when you trade the pair GBP/JPY, you have to watch out for what's going on in both Japan and England. Now, that's only the basics. The funny thing is, while there's nothing much going on in either of these two countries, this currency pair is actually moved by what happens in America! Reason? It's the "risk factor" that affects then Yen, which in turn affect this pair's rate.

• So what is actually the "risk factor"? The risk factor of a currency depends on both geopolitical stability and interest rate. When there's nothing of warfare nature going on, this risk factor depends mostly on interest rate. JPY has been considered low risk because it has the lowest interest rate among the majors: only 0.10%, followed by the USD at 0.25%. On the other end, you may see the higher risk currencies such as NZD and AUD. To get more return, traders borrow the low-interest Yen to invest in higher-interest currencies, the activities known as carry trades. The US dollar, however, has always been considered low risk (and hence, low return) mostly because of the size of the US economy. When you buy a treasury note (underlying the stability of the USD), you'll know it's the safest investment you can get. The reason is that as large and strong as the US economy, the USD will not likely evaporate in thin air.

  With the risk factor in play, traders value USD and JPY more when they perceive more risks in the market (stock market down). On the other hand, when the economy is perceived as stable, they would dump these low-risk currencies in search of higher-return counterparts, the concept known as "risk appetite" in the trading world. In conclusion, if you narrow your forex portfolio down to major pairs and Yen-crosses, then you need only look at the stock market to make your trading decisions.

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• Yen as Proxy for Risk Aversion

       

   

  The US stock market has lost over 10% of its capitalization since reaching an all-time high in October of last year.  Meanwhile, the Japanese Yen has climbed at least as much in proportional terms since bottoming out around the same time.  Coincidence?  At least one analyst doesn’t think so. Because of the steadfast popularity of the carry trade, the Japanese Yen appears to have developed an inverse correlation with the US stock markets.  The reasoning is actually quite simple. When aversion to risk is low, investors borrow in Japanese Yen and make investments denominated in other currencies, the Dollar for one.  When risk-aversion increases, as it has in the current economic environment, investors have been quick to close out their carry trade positions, causing the Yen to rise. Maktoob Business reports:

   

  If the situation of stock markets is improving, the USD/JPY is likely to be increasing. It means that more carry trade transaction are being carried out.

   

   

  Read More: Fundamental analysis - Market Correlations