In the last twelve months we have seen many of the once traditional correlations in the currency market breakdown completely, as fundamental forces dictated the principle direction for certain currencies, with investors rushing from one market to another as each fresh piece of news sent shock waves into the financial markets, and in particular in paper based assets.
When I first began trading in the forex markets, there were certain correlations that could be relied upon to work well and consistently over relatively long periods of time, and as such provided excellent mechanisms for hedging one trade with another. The traditional one of course was the correlation between the euro dollar and the pound dollar, a positive one generally around +0.9, with a rise in one reflected with an equivalent rise in the other. In order to hedge a position it was simply a case of opening a long position in one, with a short position in the other, which would then provide good hedge which could be weighted one way or the other with additional contracts. Another of course was the USD/CHF, which worked as a negative correlation with the EUR/USD ( generally well above -0.90), with a fall in one currency reflected with a rise in the other, and again providing a simple strategy for hedging a spot trade. Since then, the world has changed dramatically with only the USD/DKK remaining as one of the few reliable correlations with the EUR/USD, with an almost perfect inverse relationship.
These changes have of course been as a result of the economic pressures which have demanded action from central banks and regulatory authorities, as currencies themselves came under pressure or were seen as a safe haven status in turbulent times. One such was the Swiss Franc, which has strengthened dramatically against the US dollar falling from a high of 1.1731 in May to trade at 0.9328 today, as investors flocked to Switzerland and the sanctuary of the Franc and abandoning the once safe haven of the US dollar. The same effect was repeated in the EUR/CHF which moved from a high of 1.5139 to close the year at 1.2505. In Europe of course, the single currency has had it’s own problems, having come under increasing pressure as sovereign debt issues, potential defaults, the risk of contagion, and near banking collapses have all added to the woes for the euro over the last twelve months. Indeed one of the continuing, and ongoing debates is whether the euro will survive in the longer term as euro sceptics jump on this particular band wagon, led in no small part by Germany who are becoming increasingly concerned at the role it is now playing, as the rock of Europe in both monetary and economic terms.
In the US, the once mighty dollar has also been under pressure, as the FED continues its desperate bid to prevent inflation returning to a weak economy, as it pursues a policy of quantitative easing in an attempt to kick start the economy, with the second round now well under way. This of course has raised objections in Europe with the accusation that this is nothing more than currency devaluation by another name. Finally, as always, there is talk of whether in the longer term, the US dollar will continue to remain the currency of first reserve, and if not, could this be replaced by the euro. At present there is no clear answer with both the euro and the dollar struggling with their own particular problems, but the prospect of a shift from the US dollar is unthinkable in my view, and the ramifications for the forex market would be cataclysmic.
So, to come back to the start – will the old correlations ever engage once again, and if so when. Unfortunately I cannot answer the second part, as this largely depends on how soon the risk of contagion dissipates in Europe, and whether inflation does indeed take hold in the US. What I can say is that they will return once the status quo is re-established, but the last twelve months have been a wake up call to us all, and has taught us some valuable lessons, in that whilst correlations do work well some of the time, they are not a guarantee of success, and to be consistent in our trading we need to monitor these relationships closely, look at the longer term correlation periods to ensure that they are reliable, and above all, not become a slave to one or another. There are many other markets which provide hedging opportunities such as in options or futures, as well as in other markets, such as in commodities, so as traders we need to think a little harder than in the past, and to look outside the confines of the forex world for more creative ways to hedge in the future.