Trading Tips

On Safe Havens and Currency Pair Correlations

I usually think the stuff put out by OANDA is pretty solid, but a post on their blog yesterday definitely fell short of that standard. Using their correlation matrix – which I do think is very useful and which I posted about on Facebook and Twitter not long ago – the author looked to make the case that USD/CHF is the best safe haven current pair.

First of all, currency pairs are not safe havens. That only works with individual currencies. At various points in recent years the USD, the CHF, and even the JPY have been tagged as safe haven currencies. This is an indication of where global capital is likely to move during times of stress. The result is that when the markets are risk-off, money will flow from risk currencies (currently the likes of the EUR and AUD) into safe haven currencies, and that will reverse with the markets go risk-on. This tends to make the pairs which join up safe haven and risk currencies (AUD/USD, for example) particularly volatile in times of shifting market psychology.

Shifting to the OANDA blog author’s argument, though, we get into the area of correlation. The point made is that USD/CHF is almost perfectly negatively correlated to EUR/USD in nearly all time frames. Let’s think about what those causes are:

1) The USD positions in the two pairs are opposing
Any two currency pairs which have the USD in them are going to be fairly strongly correlated most of the time. Whether that is negative or positive depends on whether the USD is in opposing positions in the pairs (base in one, quote in the other) or in the same position (base in both or quote in both). In the case of EUR/USD and USD/CHF we have the dollar as quote currency in one and base currency in the other, so we have a natural negative correlation.

2) The EUR and CHF tend to be influenced by common factors
This means both the euro and franc have a long history of seeing their values rise or fall on the basis of the same news and fundamental information. As a result, they tend to move in the same direction most of the time, though the amplitudes of the moves does vary (which is the cause for movement in EUR/CHF). Because EUR/USD and USD/CHF have the two currencies in opposing positions (as noted with the dollar above), there is a natural negative correlation between the pairs.

3) The Swiss National Bank has put a floor under EUR/CHF at 1.20
Because of the persistent issues in the Eurozone and the perception of the franc as a safe haven (meaning flows out of the EUR and into the CHF), this has effectively mean EUR/CHF has been pegged at or near 1.20 for long period of time of late. That means the euro and franc have traded in near lockstep. Going back to the relationship between EUR/USD and USD/CHF noted in 2) above, this is the strongest case of all for a very strongly negative (near -1) correlation between the two pairs.

Put all this together and you get the reason for USD/CHF trading at a near perfect negative correlation to EUR/USD being that the EUR and CHF are virtually the same currency these days, and both pairs feature the same opposing currency (USD) on the other side. Of course they are going to be strongly negatively correlated!

Because of the strong negative correlation between EUR/USD and USD/CHF, hedgers may look at the two as presenting an opportunity. I would note, however, that being long EUR/USD (for example) and hedging with a long USD/CHF position would only serve in creating a synthetic (and overly expensive) EUR/CHF long position.

The bottom line with the correlation stuff, which seems to get everyone very excited these days for some reason, is that it’s important to know why two markets are correlated (or uncorrelated). If you don’t, then you may find yourself in a nasty position where the correlation breaks down and catches you out because you weren’t prepared for it based on an understanding of the market dynamics at work.

And getting back to the idea of USD/CHF being the best safe haven currency pair… I’m sorry, but just looking at the correlation to EUR/USD alone is a far cry from sufficient evidence to make such a claim. You’d have to do a full analysis to see which pair or pairs is most reactive to safe haven capital flows before making any claims. Correlation analysis doesn’t get you there.

The Basics

Most Active Forex Currency Pairs

(Note: See Most Traded Currency Pairs for up-to-date info) The question comes up a lot as to what the most actively traded currency pairs are. A lot of forex traders end up responding based on what they think people trade most without necessarily knowing the statistics. Well, now you can be educated on the subject because I’ve got some data to share with you based on official figures (as of October 2008). This information comes from Forex volume survey, Forex volume survey, a presentation compiled by a former colleague of mine (originally posted on Kathy Lien’s website – at least that’s where I saw it).

Here are the highlights.

London is by far the most active trading center, handling something close to $1.5 trillion in flows per day on average. It does roughly twice what second place NY does, with NY being a little higher than the Sydney/Signapore combined total. (Note: Tokyo was not included in the study, nor was anything from the Europen Continent).

The spot forex market is not the largest component of forex trading, despite what you might have heard. It’s actually the swap market which is the largest part. Given that most forex trading is actually related to international trade and capital flows, this really shouldn’t come as a surprise. Interestingly, though, spot trading is by far the biggest part of forex trading in the NY market.

In NY trading, EUR/USD accounts for about a third of all forex action. USD/JPY is about 20%.  The trio of EUR/JPY, GBP/USD, and USD/CAD make up the rest of the pairs accounting for 75% of the trading activity on average.

EUR/USD is actually more like 40% of London trading. USD/JPY is still in second position, but at a lesser amount than in NY trading (call it 15%). GBP/USD is slightly less than USD/JPY. The group of EUR/JPY, EUR/GBP, and USD/CHF make up the rest of the top 75%.

Not surprisingly, AUD/USD is the biggest pair traded in Sydney (about 25% share), but EUR/USD and USD/JPY are the next two most active pairs, and in Signapore they are also 1/2 as they are in the rest of the world.

So the bottom line is that EUR/USD and USD/JPY are the two most actively traded currency pairs in the forex market. GBP/USD is third, with EUR/JPY generally forth.

I encourage you to check out the report, and if you are day trading check out the data for the trading center that’s the focal point for when you are in action. It might help you better find good trading opportunities. Of course, this isn’t to say that the lower volume pairs aren’t worth trading either. It just depends on your needs.