Market Correlations – What and Why?

Have you ever noticed certain FX currency pairs moving in a way that’s correlated to another FX currency, Commodity or Index? In this blog post I will list the main market correlations that I know of and explain why they are apparent and how to use them in your trading. Let’s begin.

Firstly, let’s talk about what “correlated” means. The word correlate means to have a relationship with or connection, in which one thing depends on or affects another. In simple terms, it means that 2 things are linked and the actions of one affect the other. Correlation can be both positive and negative depending on how the two things in question affect each other. For example, there is generally a positive correlation between increased driving speed and fuel consumption. The faster you drive a vehicle, the more fuel you will use. There is generally a negative correlation between the number of cigarettes you smoke and life expectancy. The more cigarettes you smoke, the shorter you will live.

Standard Correlations

In terms of trading the financial markets, correlations are normal relating to the price of 2 instruments. For example, the price of Gold has an affect on the value of the Australian Dollar thanks to links between the two and I will explain what these links are in this blog post.

Personally I take notice of 4 main market correlations. I know there are probably a lot more than 4 but these are the ones I know of and monitor because they relate the most the main markets I trade. As always, they will be all centred around the FX markets because that is my specialty. They are as follows:

Gold (spot) & Australian Dollar

Crude Oil & Canadian Dollar

Great British Pound & FTSE 100 Index

Gold (spot) & Swiss Franc

I will explain why each of the correlations occur and show you the price charts to prove the correlation exists and more importantly, identify the type of correlation. Knowing these correlations exist and why can be extremely important if you are trading the instrument involved over a longer time period.

Price Correlation 1 – Gold & Australian Dollar (AUD)

Correlation Type – Positive

Monthly Price Line Chart
Australian Dollar vs USD (Blue) & Gold (Black)

As you can see from the price chart above, there is an identifiable positive correlation between the price of Gold and the value of the Australian Dollar. As the price of the precious metal increases over time, so does the value of the FX currency pair when pegged against the USD.

There is a very good reason for the positive correlation. The country (and continent) of Australia is the 2nd biggest gold producer in the world falling behind China. In 2017 Australia contributed to nearly 10% of the total global gold production for the year… that is 300 metric tonnes of the shiny yellow metal. Therefore when the price of gold goes up, the value of their gold production (per tonne) increases and this will benefit their economy. The strength of the correlation between these 2 instruments has dropped off in recent years but it is still very apparent and a good example to use when describing correlations within the financial markets.

https://en.wikipedia.org/wiki/List_of_countries_by_gold_production

In regards to using this correlation to trade, there are 2 methods you can use.

Method 1 would be to monitor gold price and production levels. If you see the price of Gold increasing then it would make reasonable sense to then buy Australian Dollars in the hope that it follows suit and the value also rises. Taking advantage of the positive correlation between the 2 instruments. However, the genius’ amongst you have probably already realised that you could just buy spot gold and benefit from the increase in the value.

Method 2 is a little more interesting. If it is common for these 2 instruments to move in synchronisation then there are greater trading opportunities to be found when they are doing the exact opposite of this. Occasionally it is possible to see the values of Gold and AUD diverging and not acting in relative correlation and this can be when the greatest trades occur. You can do a simple hedge trade and buy the undervalued instrument and sell the overvalued instrument in the hope that they then continue their correlation and the 2 instruments come back to join each other once again.

An important thing to remember with this market correlation is that it is a one way relationship. The price of Gold influences the value of the Australian Dollar but the value of the Australian Dollar has little to no impact on the value of Gold.

Price Correlation 2 – Crude Oil & Canadian Dollar (CAD)

Correlation Type – Positive

Monthly Price Line Chart
Canadian Dollar vs USD (Blue) & Crude Oil (Black)

Another example of 2 financial instruments with a positive correlation is the price of Crude Oil and the value of the Canadian Dollar (CAD). In my opinion, this correlation is even stronger than Gold and the Australian Dollar and you can see this on the chart above. The blue is the price of the Canadian Dollar against the USD and the black line is the price of Crude Oil (per barrel). The 2 lines almost follow each other exactly.

So why does the price of Crude Oil influence the value of the Canadian Dollar? It’s because Canada is a huge producer and exporter of Crude Oil and the sales of Crude Oil is the single biggest contributor to the foreign exchange of Canadian Dollars. In order to buy Crude Oil, foreign buyers need to purchase Canadian Dollars and this then increases demand and price of the currency. Therefore, if the demand for oil increases then so does the price and this will then intern drive up the price of Canadian Dollars through the same principles.

Unsurprisingly, Canada is not the worlds biggest producer of Crude Oil. This trophy is given to the USA with Russia and Saudi Arabia coming in 2nd and 3rd. Canada does have the 4th largest Crude Oil reserves in the world however the main reason for the strong correlation between the Canadian currency and Crude Oil price is due to the number of exports of the black liquid gold. The Canadian economy is export based with over 30% of GDP coming from exports and a large percentage of this is from the exporting of Crude Oil.

https://www.theglobaleconomy.com/Canada/Exports/

Much like other positive correlations within the markets, there are a few ways you can use this information when trading. I will keep this brief to save explaining myself twice.

One option is to monitor Crude Oil reserves, production levels and prices in order to predict whether the price will rise or fall in the future. Due to the strong positive correlation with the Canadian Dollar you can then use this when trading the FX currency pair.

The other option is to monitor the divergence between the 2 instruments themselves. Due to their strong correlation, it is safe to assume that any large deviation in the price of the 2 instruments will be reversed and reduce in the future. You can then use this information to hedge the markets of both Crude Oil price and the value of the Canadian Dollar.

As with the first market correlation (Gold & AUD), it is important to remember that this market correlation is that it is a one way relationship. The price of Crude Oil influences the value of the Canadian Dollar but the value of the Canadian Dollar has little to no impact on the value of Crude Oil.

Price Correlation 3 – Great British Pound (GBP) & FTSE 100 Index

Correlation Type – Negative

4 Hour Price Line Chart
Great British Pound (Blue) & FTSE 100 Index (Black)

The correlation between the Great British Pound (GBP) and the FTSE 100 index is a little different to the previous market correlations explained in this blog. Firstly, you will notice I have listed the name of the FX currency before the Index. This correlation also involves and Index as opposed to a commodity and the market correlation is considered to be negative. This means that if the value of the GBP decreases, the price of the FTSE 100 index increases. This correlation may not be as clear as other examples but it is still very much apparent. On the chart above you can clearly see that as the value of the GBP decreased from the highs in January, the FTSE 100 index climbed in price and then when the GBP began to climb again, the FTSE 100 began to drop off.

So why is this? Obviously, the FTSE 100 is not a commodity that is produced and exported by the UK but exports are still considered to be the key “ingredient” to this correlation. Over two thirds of FTSE 100 companies revenues are generated in regions outside of the United Kingdom. This means that a weaker Pound will make our exports appear cheaper and therefore increase demand. Increased demand will boost the revenues and profits of the companies selling the goods and services which in turn, will increase the share price and the FTSE 100 index. It is basic economics and business.

https://www.schroders.com/en/us/insights/equities/how-indexes-rise-when-currencies-fall–explained-in-two-charts/

The outer ring shows that all but 28.9% of FTSE 100 revenues are generated outside the UK.

I personally only use this information when trading the FTSE 100 index. If I am looking to enter long positions on the index then it is always good to check what the Pound is doing. If the pound is looking increasingly bullish then any upside potential for the FTSE 100 may be limited because of this.

As with the other market correlations, I believe this is a one way relationship and I don’t think the value of the FTSE 100 index has any influence on the perceived/actual value of the GBP FX currency.

It is also interesting to see when the negative correlation weakens and even reverses to become positive. This can be a sign of increased volatility and external influences having a greater effect on the economy. I believe Brexit created multiple occasions where correlation between the GBP and the FTSE 100 became positive and both the GBP FX currency and the FTSE 100 index dropped in value.

Price Correlation 4 – Gold & Swiss Franc (CHF)

Correlation Type – Positive

Monthly Price Line Chart
Swiss Franc vs USD (Blue) & Gold (Black)

The 4th and final market correlation is the positive relationship between the price of Gold and the value of the Swiss Franc (CHF) FX currency as shown in the chart above. It is very similar to the chart that shows the relationship between Gold and AUD but in my opinion, this positive correlation is stronger. The price of Gold and the value of the CHF is very closely linked and has continued to stay correlated up until the current day.

The Swiss don’t actually produce much Gold in the traditional sense because they don’t mine it and export it like Australia or South Africa. What the Swiss do is manufacture and export luxury goods that consist of precious metals like Gold and this is one of the reasons why the value of CHF is positively correlated to the price of Gold. If global demand for Gold decreases then the value of Gold decreases and in turn this means the value of the lucky exports will decrease. Similar to the example of Oil and the Canadian Dollar, this will intern reduce the demand for the Swiss Franc and therefore cause the value of the currency to drop.

Another reason why the CHF is linked to the price of Gold is the countries Gold reserves. The Swiss hold vast amounts of Gold in their reserves with over 25% of Switzerland’s money is backed by these Gold reserves.

This is one of the lesser known market correlations because not many retail traders trade the CHF FX currency.

As before, I believe this market correlation is primarily “one way” and Gold is the influencer where the Swiss Franc is the follower.

So there we have it! Four financial market correlations, with explanations on why they occur and how to incorporate them within your trading strategy. I hope you have enjoyed this blog post and learnt something new.

Happy Friday and I hope you all have a great weekend!

All price analysis and charts have been created using the DailyFx website or the TradingView platform. I highly recommend both of these to technical traders who are looking for a charting software to use.

DISCLAIMER: None of the information posted on this site is to be considered investment/financial advice. Trading is high risk and you should only trade with money you can afford to lose.

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