Knowledge of intermarket correlations can improve your forex trading win rate.
Here I explain three important types of correlations, and how you can use them to benefit your trading.
Most algorithmic traders like myself swear by technical analysis.
Nonetheless, adding fundamental analysis to your forex trading, in the form of intermarket correlations, could help improve your win rate.
Let’s dive into the three most important types of forex intermarket correlations.
Correlations With Interest Rate Differentials
Interest rate differentials have been the most consistent driver behind currency valuation. This is because investors favour currencies that pay higher interest.
If a particular economy is doing well, its currency and interest rates tend to increase in tandem.
An interest rate hike is thus a strong predictor of an upcoming rise in currency value. Central bank speeches and interest rate decisions are among the most keenly anticipated events on the forex calendar.
Currencies rise or fall depending on the market’s expectation of an upcoming interest rate decision. If the central bank signals an intention to increase rates, the currency often rallies significantly.
Unexpected changes in interest rates lead to violent moves in the market. The chart below shows how the AUD tumbled when the central bank unexpectedly cut rates from 2.00% to 1.75% in May 2016.
Since forex traders deal with currency pairs, what matters is not the interest rate per se, but the interest rate differential between the two currencies of interest.
This interest rate differential is usually correlated with the currency pair’s movement. The chart below shows how the AUDUSD closely tracks the differential between the 2-year Australia government bonds and the 2-year US government bonds.
As the Australian bond yields decrease relative to the US bonds, the AUD depreciates relative to the USD.
Correlations With Commodity Prices
1. USD Markets
The USD tends to have an inverse relationship with commodity prices. There are two reasons for this:
- Commodities are usually priced in USD. A stronger USD makes commodities more expensive for consumers, reducing demand and pushing commodity prices lower.
- When commodity exporters sell their products, they are paid in USD. To balance their assets, exporters often sell USD and diversify into other currencies. The greater the demand for commodities, the more USD is sold off.
2. Commodity Currencies
There are three main commodity currencies: CAD, AUD, and NZD. These countries are huge exporters of the following products:
Stronger demand for these commodities is bullish for the currency.
Let’s take CAD for example. When oil exports increase,
- Canadian businesses receive more USD, and subsequently convert this to CAD to sustain their local operations.
- Canadian GDP and employment numbers etc. improve, which may in turn raise interest rates.
These create demand for the CAD.
The chart below shows the inverse relationship between the USDCAD and WTI oil.
The 2014 oil price crash, triggered by booming US shale production, led to a sustained USDCAD rally.
Correlations With Other Currency Pairs
Being the most heavily traded currency, USD pairs tend to move in tandem.
Take the EURUSD for example. Making up almost 30% of forex turnover, most traders use it to express their view on the USD.
The chart below shows how the EURUSD, GBPUSD, AUDUSD and NZDUSD moved in tandem for most of 2020/2021.
If the EURUSD is bullish, and barring major changes in non-USD currencies, chances are the other majors will behave as follows:
How to Trade Forex Correlations
Armed with your knowledge of forex correlations, here’s one way you can fine-tune your trade selections.
- Shortlist currency pairs that have diverged from the markets they are traditionally correlated to.
- For these currency pairs, you may implement a long/short only trade filter, or amend your position sizes.
- Enter the market using your existing strategy rules.
I’ll demonstrate this using forex correlations with commodities.
Trading Forex vs. Commodity Correlations
The correlation between CAD and oil price is reliable and persistent, so I’ll use it for illustration.
Suppose I’m trading the 1-hour USDCAD, and I’m looking to exploit a divergence between CAD and oil price.
A divergence is present when both USDCAD and oil are bullish, or when both are bearish.
The chart below shows the 1-hour WTI crude oil overlaid on the 1-hour USDCAD. Note that the crude chart has been inverted for clarity, showing a clear divergence between the two markets.
To figure out what’s driving this divergence, I turn my attention to USD Index (DXY). This index measures USD strength against a basket of six foreign currencies.
The DXY at the time of the divergence is shown below:
It turns out the USD is experiencing a strong rally, triggered by the Federal Reserve bringing forward its projections for the next rate hike to 2023.
The USD does look overbought though, having had three consecutive penetrations of the upper Bollinger Band on the daily timeframe.
I am therefore bearish on the USDCAD for the following reasons:
- Crude oil is bullish.
- USD looks overbought; I expect a correction soon.
- The 1-hour USDCAD is at a daily resistance level and the shooting star shows strong rejection of price.
As long as the divergence between USDCAD and oil persists, I will avoid going long on the USDCAD.
I’ll short USDCAD if my existing strategy entry conditions are met.
Shorting USDCAD at the instance above, perhaps by using Bollinger Bands/Donchian Channels/Shooting Stars to detect a false breakout, would have yielded about 150 pips.
I don’t recommend solely using correlations as the basis for entering a trade, although there are many short-term algorithms that specifically exploit tiny divergences.
I prefer to look for confluence between fundamental and technical setups.
Two Caveats on Using Forex Correlations
1. Spurious Correlations
A spurious correlation occurs when there appears to be a causal relationship between two variables, when in reality the variables are randomly moving in the same direction at the same time.
There is a hilarious website that documents many of these spurious correlations.
2. Shifting Correlations
Correlations are not set in stone; today’s legitimate correlations may stop working tomorrow, or gradually fade into obscurity.
An example of this would the weakening correlation between EUR and GBP after Brexit.
How do you avoid falling prey to these caveats?
The key is to look for fundamental reasons behind the correlation. Are there economic drivers behind the relationship?
The three types of forex correlations explained above all have a fundamental basis. This makes them more reliable and persistent.
Understanding intermarket forex correlations can help fine-tune your entries and improve your win rate.
Even if you do not use correlations to inform your trade decisions, it’s a good idea to understand the economic drivers behind the markets.
When searching for correlations, be sure to select a lookback period that tallies with your trading timeframe.
Your lookback period should be short enough to let you detect temporary divergences, without introducing too much noise to your charts.
If you’re a short-term trader on the 1-hour timeframe or less, looking for correlations over a three-month period makes sense. If you trade the daily timeframe, a few years is an appropriate window.