Dollar firms as Iran deal hopes fade: what currency correlation means

The dollar firmed in the 3 November ECB reference rates, reversing part of Monday's slide. EUR/USD's fixing fell 0.33% to 1.1179 and AUD/USD's fell 0.35% to 0.6984, as hopes for a US-Iran deal faded and markets turned cautious on US midterm election day.

According to investingLive, the optimism that sent oil lower on Monday had largely unwound by Tuesday, leaving things "pretty much back where we started." Investing.com reported that the Australian dollar hit a two-week low. Later in the day, investingLive reported that US job openings came in at 7.523 million against a 7.100 million estimate, and September factory orders rose 1.8% against 1.2% expected. Our sister site has a full rundown of the dollar's day around the JOLTS data.

What is currency correlation?

Currency correlation describes how often two currency pairs move in the same direction, or in opposite directions.

• Positive correlation: two pairs tend to rise and fall together. EUR/USD and AUD/USD often do, because both are priced in US dollars. When the dollar strengthens broadly, both pairs tend to fall.
• Negative (inverse) correlation: one pair tends to rise when the other falls. EUR/USD and USD/CHF often behave this way, because the dollar sits on opposite sides of the two pairs.

Correlation is a tendency, not a rule. It can weaken or flip when one currency has its own news.

A worked example

Start with today's two fixings, from the ECB reference rates:

1. EUR/USD: 1.1179 minus 1.1216 = -0.0037. Divide by 1.1216 and you get about -0.33%.
2. AUD/USD: 0.6984 minus 0.7008 = -0.0024. The ECB data puts that at -0.35%.

Both fell by a similar amount on the same day. That is positive correlation at work: one common driver, a firmer dollar, pushed both down.

Now look at the past four daily changes in the fixings:

EUR/USD and AUD/USD moved the same way on only 2 of 4 days. Over five fixings, EUR/USD is up 0.26% while AUD/USD is down 0.68%. So the pair that looked tightly linked today has drifted apart this week. EUR/USD and GBP/USD matched on 3 of 4 days. EUR/USD and USD/CHF moved in opposite directions on 3 of 4 days, which fits the expected inverse link.

One more check: USD/MXN fell 0.65% to 18.597 today. The peso gained on the dollar while the euro and Aussie lost ground. A broad dollar move does not hit every currency the same way.

You can compare the pairs on EUR/USD and AUD/USD charts.

Why it matters for new traders

Many beginners open positions in several pairs and think they have spread their risk. If those pairs are positively correlated, they may really hold one large bet on the dollar. A single surprise, such as a strong data release, can then move every position at once.

Correlation also helps you read the market. When EUR/USD, AUD/USD and GBP/USD all fall together, the story is probably about the dollar. When only one pair moves, the story is probably about that one currency. This week, the Aussie's steady slide while the euro rose points to something specific to Australia, not just the dollar.

Finally, remember that correlations change. A link that held last month can break when central banks, elections or geopolitics pull currencies in different directions.

Key terms

• Currency correlation: how often two pairs move together or apart.
• Positive correlation: pairs that tend to move in the same direction.
• Negative correlation: pairs that tend to move in opposite directions.
• ECB reference rate (fixing): an official exchange rate the European Central Bank publishes once per business day; not a live quote.
• JOLTS: a US report on job openings, hires and quits.