Forex's Peculiar Ties to Other Markets

Forex is not a watertight compartment. In truth, no market is. In a globalized world, it is impossible for a market to develop independently from all others (it was not even possible in previous eras). Therefore, it is possible to examine the links between Forex and other markets not only for statistical purposes but also for analytical and operational ones. In short, it is beneficial to study the correlations between Forex assets and assets from other markets to draw conclusions about the present and future of the currency market. Correlations are a fascinating and, in some ways, revealing topic that we will try to address in this article with sufficient detail. Specifically, we will introduce and explore the concept of correlation, listing the implications for trading activity. We will then discuss correlations in Forex, offering information about the relationship between specific currencies and equally specific assets (pertaining to other markets, from commodities to precious metals).

Correlations, a powerful tool

But what exactly is meant by correlation? Well, correlation is the measure of the relationship between two variables, in this case between two assets. For various reasons, ranging from investor perception to robust economic dynamics, the movements of two assets can go hand in hand. In this case, we speak of positive correlation when two assets move together in the same direction; we speak instead of negative correlation when the growth of one asset regularly corresponds to the decrease of another asset, roughly following the same pace. Correlation is expressed with values that fall within the range -1 +1. In a nutshell, when a correlation is perfectly positive (i.e., it always occurs, and each time with the same strength), the parameter returns a value of +1. When the correlation is perfectly negative, on the other hand, the correlation returns a value of -1. When the value is equal to zero, this very simply indicates an absence of correlation. That is, the assets are not connected to each other. Why are correlations important? They are important for two reasons. Firstly, they allow for correct and effective diversification. If the fear is that of failing a particular trade, it is possible to open an equal and opposite position with a positively correlated asset in an attempt to minimize the potential loss. Secondly, correlations offer analytical insights. Often one possesses material for the analysis of only a few assets, but nevertheless it is possible to trade even with more uncertain assets, if correlated (positively or negatively).

Correlations in Forex

What can be said about correlations in Forex? First, that they not only exist but play a fundamental role. It could not be otherwise: Forex deals with currencies, which are necessarily linked to other markets as money is the lubricant, the conditio sine qua non, of any trading activity. Apart from these dynamics that look more at logic than at other aspects, precise correlations can be traced between some currencies and some extra-Forex assets. In the following paragraphs we will give an account of the most important correlations, currency by currency.

Dollar correlations

The dollar is the most important currency in the world, so it is not surprising that it boasts many correlations, both internal and external to Forex. However, one plays a really important role: the correlation with gold. The reason for this correlation is both economic and perceptual, of soft power. The dollar, being the most important currency, is in contrast with gold, which is the safe-haven asset par excellence. The growth of one, therefore, corresponds to the decrease of the other. Thus, we are facing a strong and negative correlation. The correlation has, in some ways, also a purely technical character. In fact, the value of gold is generally expressed in dollars, so it is inevitable that they are negatively correlated. This correlation is "convenient" both for Forex traders and for precious metal traders.

Euro correlations

The euro can be defined as the second most important currency, also because it expresses the strength of a very flourishing, imposing economy, capable of placing itself above even China (if we aggregate the economies of the euro area countries, of course). Well, on the euro front, at least two important correlations should be noted. The first is internal, and it is with the dollar. Again, nothing to be surprised about: the euro and the dollar are traded in pairs, so when one revalues, the other devalues. But there is more: from the beginning, the euro and the dollar have "fought" for the qualification of most important currency. Therefore, the correlation is strong and negative. The second correlation is the one with gold. It is a matter of transitive property: if the euro is negatively correlated with the dollar, and the dollar is negatively correlated with gold... Then the euro is positively correlated with gold. All very simple and didactic.

Pound correlations

As for the pound, we will mention only one correlation, which however is very important from an economic and financial point of view. We are talking about the correlation between the pound and the price of oil. Well, this is a strongly positive correlation. What does oil have to do with the English currency? Simple, energy production is a fundamental component of the UK economy. It is estimated, in fact, that a good part of UK GDP depends on the extraction of energy raw materials and their treatment. Indeed, as many as 25% of the companies listed in the FTSE 100 are related to the oil and energy sector. So, when the price of oil rises, the pound tends to rise. The opposite happens if the price of oil falls. This is especially true for Brent, but also for WTI.

Yen correlations

The discourse for the yen is radically different. In fact, the yen is characterized by a strongly negative correlation with the price of oil. In a nutshell, if the price of oil rises, the yen tends to depreciate. If the price of oil falls, the yen tends to revalue. What is the reason? Well, the reason is essentially economic. In fact, the Japanese economy is based on exports, so it suffers when energy prices rise, as production costs and logistics costs increase. It follows, but this is an intra-Forex overview, that the yen and the pound are negatively correlated.

Swiss franc correlations

The discourse on the Swiss franc is a very particular one. The Swiss currency, in fact, has a very strong correlation, but not with respect to an asset, but to a dynamic. In reality, the Swiss franc tends to move, and to move upwards, especially when the global context goes through periods of uncertainty, when wars break out, geopolitical chaos, economic crises, etc. The reason is somewhat intuitive: the Swiss franc is considered a safe-haven asset, almost on a par with gold. Investors, when faced with periods of uncertainty, when they have lost their bearings, tend to refer to the Swiss franc. If we really want to find a correlation with an asset, we can find it with gold. In fact, they are governed by the same dynamics and serve the same function (without, however, stepping on each other's toes too much).

Canadian dollar and Australian dollar correlations

To conclude, a look at two currencies that are "a little less traded" than the majors we have dealt with in the previous paragraphs: the Canadian dollar and the Australian dollar. Well, both currencies are correlated to commodities, to raw materials. The reason is also, in this case, purely economic: the economies of the respective nations, Canada and Australia, are based on the sale of raw materials. So, when raw materials revalue, for Canada and Australia there are greater gains, and Canada and Australia also benefit positively. Obviously, a distinction must be made between commodities, as the two countries are well differentiated from this point of view. Specifically, the Canadian dollar is correlated mainly to copper, nickel and cobalt. The Australian dollar is more correlated to iron, lead and coal (all raw materials necessary, among other things, for the development of China, which is in fact one of Australia's major partners).