Correlation, in simple terms, is a statistical measure that indicates the extent to which two sets of data move together. It’s expressed by a number between +1 and -1 (if there is no correlation, this will be 0). The higher the figure (closer to 1), the more likely it is that movement in one data set will result in movement in another set, and vice versa.
A correlation is when two pairs are ‘linked’ somehow; since one rises when another falls or vice versa, they are correlated. It doesn’t happen all of the time, and there must be a reason why, so we need to look at what causes this phenomenon and how we can use it to our advantage.
Four Key Factors Influence Currency Pairs Correlation
Economic Factors
It is the main factor because if you know what is happening with the economy, you’ll have a good idea of whether currency prices will rise or fall. For example, let’s say we have the EUR/USD. If the Euro starts to rise, this is good news for Europe as a whole (positive economic news) and usually leads to other European currencies such as the GBP/USD rising as well.
Political Factors
It’s crucial for governments not only to stick together but also to look after their best interests. For example, if we have the USD/CHF and the USD is rising, this would be good for America. Still, Switzerland doesn’t want its currency to drop, so they will usually raise interest rates (making their currency more attractive) which causes the US dollar to fall.
Sentiment
The mood of the market can also influence pairs to move in correlation with each other. If, for example, the EUR/USD falls and everyone thinks that this is bad news (and, as a result, sell their positions), then sentiment can cause many pairs to start falling.
Market Sentiment
It is similar to the previous point but looks at whether pairs tend to move together over some time. Knowledge is power when dealing in the financial markets, and knowing which pairs correlate with others can help you make an informed decision about your next trade.
This one is quite hard to predict, but watching trends on social media or financial TV shows is one way to read into it. Look at the trends on Saxo Bank and test whether you can predict the market sentiment.
Why Trade with Currency Pairs Correlation?
It’s not always apparent why currency pairs move together, but ultimately it comes down to one of the four factors listed above. Economic factors are by far the most significant when you look at long-term trading, but short-term trading is also influenced by Sentiment and Market Sentiment.
Political beliefs can also trigger a movement, and this was seen after the Brexit vote in the UK; some currencies dropped while others rose. Let’s consider that correlation has had an impact on markets up to now. We may understand that we need more knowledge about it to use it to our advantage – such as knowing which currency pairs correlate with each other so you can make informed decisions about your next trade.
In Conclusion
Currency pairs are said to be in a state of co-movement if their exchange rates tend to maintain an equilibrium. Most currencies are correlated, but that does not mean that any two currency pairs are bound to have the same correlation coefficient. If two currency pairs correlate positively, they follow the same general trend in price increases and decreases.
Several factors influence how currencies behave concerning each other when placed within different baskets or groups. For example, there is a strong negative correlation between various regions, including the United Kingdom’s pound against the Euro or US dollar.
These three major economic blocks all experience similar political decisions that regulate economies in similar ways, thus causing their respective exchange rates to move closer together.