Financial Markets Correlations and How They Change
One of the trickiest things in trading and investing is to understand correlations between financial assets. Failing to do so leads to a portfolio that ends up somewhat overweight on a particular asset, or underweight – both leading to underperformance.
The problem with correlations is that they change in time for no obvious particular reason.
For many years, the USDJPY pair moved hand in hand with the US equity markets. The so-called carry trade was responsible for the direct correlation between the two assets, as investors used the JPY to borrow funds for margin trading. Not anymore!
Market Correlations to Consider These Days
One of the strongest market correlations to consider is the one between the AUD pairs (in particular the AUDUSD and AUDJPY) and the US stock market (S&P500). As the stock market plunged at the start of the COVID-19 crisis in March this year, the AUD pairs fell into the abyss too. However, the stock market recovery led to the AUD pairs recovery as well.
Nowadays, the stock market moves almost tick by tick together with the AUD – higher S&P performance leads to higher AUDUSD. The driver, to be sure, is the index, not the FX pair. The AUD’s strength directly influences the EURAUD cross. Known as a pair that rises in a risk-off environment and falls in a risk-on one, the EURAUD pair declines when the stock market rises, and visa versa.
Hence, the stock market flows influence the AUD flows, which, in turn, influence the EUR flows. This leads to an interesting occurrence that actually happened yesterday. At one point, FX correlations looked very strange, the EUR was up significantly while the S&P index was down – something that is unusual in the absence of some form of EUR news.
The point here is that any market correlation works until it does not anymore. Sure, some correlations exist longer than other ones, some are stronger during different moments of the business cycle, and so on.
To base an entire strategy on market correlations is not wise. To ignore them completely is also not recommended. What works is to diversify the trading account well-enough to weather any storm and to use correlations to hedge against unwanted market moves, for a win-win situation.