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.

Thresholds, Tipping Points, Good & Bad News

It is not news that news moves financial markets. This blog will publish research on how, when, why, and which news moves what financial markets.

Traders often will set threshold for action and in aggregate this might explain why some announcements are a “scratch” from a trader’s perspective that is there is a move but not enough to act upon. Once the threshold is breached though, lots of people want in.

The move from disorder to order or the contagion effect has been used to explain financial crises. Perhaps it can also be used to explain markets reactions to news too.

Looking at the impact of the Non-Farm Payrolls (“NFP”) announcements in the U.S. on the Euro (EURUSD) exchange rate, a couple of thresholds appear to be important. Interestingly the threshold is larger for bad news than for good news.

Good news and bad news have different effects also the skew of the expectations is important. These effects have been discussed before but if the news is very good or exceptionally bad there is an extra kicker. So, negative news is more likely to be a non-event than good news from a trading perspective.

The thresholds that were found to be statistically significant were when news was greater than one standard deviation and when news was less than two standard deviations from what was expected (as measured by the economic derivatives auction for NFP).

Thresholds and Contagions, Particle Physics to Zoology to Finance - A Cross Pollination of Ideas

It is not news that news moves financial markets. This blog will publish research on how, when, why, and which news moves what financial markets.

In the Michaelmas 2006 (Volume 19 No. 1) issue of Oxford Today there was a report that Oxford zoologists were using a particle model from physics to explain why locusts swarm. “As locusts gather, individuals move around randomly – but only up to a point. Once there are more than 70 locusts per square meter, they spontaneously align themselves and all march together, devastating crops in their path”.

“Dr Jerome Buhl and his colleagues, reporting in the journal Science¹, believe the mathematical rules will apply to a wide range of group animals, from fish to moose, and perhaps even to human crowds.”

The threshold effect is something I have wanted to test for the announcement effect. Once a financial market moves by a certain threshold amount then all of a sudden everyone moves together, producing a swarm effect. Traders often will set threshold for action and in aggregate this might explain why some announcements are a “scratch” from a trader’s perspective, that is there is a move but not enough to act upon. Once the threshold is breached though, lots of people want in.

The move from disorder to order or the contagion effect has been used to explain financial crises. Perhaps it can also be used to explain markets reactions to news too. Stay tuned for the result …

¹Buhl, J., Sumpter, D.J., Couzin, I.D., Hale, J., Despland, E, Miller, E & Simpson, S.J. (2006) From disorder to order in marching locusts. Science, 312, 1402.