Correlation of Currencies - Normal and Stressed

Correlations can be useful tools.

FX Traders often use them to confirm movements following an announcement. For example, if a trader is expecting the EUR to appreciate following a retail sales announcement and the EUR has a negative correlation with the CHF and a positive relationship with the GBP then these currencies might be tracked to make sure the movement in the EUR is one to take advantage of.

Correlations are useful but can change in stressful times. In times of extreme financial stress correlations head toward 1 and -1. This is the contagion effect, when safe harbours disappear.

When economic news affects financial markets correlations strengthen as volatilities rise. It is important then that market participants use the right correlation for the right situation.

A while ago I posted some correlations that looked at FX rates a few minutes after major announcements. Here is the link to these posts.

Tables at mataf.net (Currencies Price Provided by the Swiss broker RealtimeForex) give correlation of currencies in more normal times. According to the website:

• If the correlation is high (above 0.8) and positive then the currencies move in the same way.
• If the correlation is high (above 0.8) and negative then the currencies move in the opposite way.
• If the correlation is low (below 0.6) then the currencies don't move in the same way.

These correlations for 5, 20 and 100 day periods will tend to average out the extremes that are experienced during announcement days and so will tend to be lower.

So correlations tend to be higher at times of stress and following economic announcements. Here is the proof.

I have taken the average correlations (currency pairs of currencies shown below with the USD vs. EUR/USD) following four major U.S. economic announcements: CPI, initial jobless claims, nonfarm payrolls, and retail sales. The correlations are plotted for data 1, 5, 10, 20, and 30 minutes following these announcements. Using the mataf.net data I also plot the 5, 20, and 100 day correlations alongside:The correlations on the right hand side of the chart are for more "normal" times.

The correlations on the left hand side of the chart are for more "stressful" times.

Notice how currencies that tend not to move together at the daily frequency do move together after annoucements. Also there is a trend towards greater positive or negative correlation the closer one gets to the announcement.

If anyone would like a spreadsheet of my calculation of the 1, 5, 10, 20 and 30 minute return correlation matrices for the U.S. announcements of nonfarm payrolls, initial jobless claims, retail sales, and CPI, please send me an email to john.parker at relevanteconomics.com.