Currencies | Mar 20 2009
By Andrew Nelson
Maybe you’ve noticed, or maybe you haven’t, but over the last several months of equity market volatility, there appears to be some emerging differences in how currencies are reacting to market movements depending on whether they are rising or falling. For example, stronger US equities are seeing small spikes in the euro and a drop on Wall Street is conversely seeing a drop in the euro.
The below table from Danske Bank clearly shows the equity market beta and correlation coefficient for 16 of the main G10 currency pairs. Of specific note are the betas for EUR/USD, which show that a 1% increase in the US equity market leads to about a 0.25% rise in EUR/USD. On the other hand, a 1% fall in US equities will lead to a 0.16% drop in EUR/USD. The bank notes that the correlation coefficients also indicate that the relation is “stronger” in an increasing stock market.
The bank came to this conclusion by sorting the daily return data for the S&P500 price index into separate sets of data. The first contained observations where the daily return is positive and another where observations are negative. It then computed betas and correlation coefficients for the daily spot return of 16 of the main G10 currency pairs using a rolling sample window of 100 days.
The following table shows the estimates for 17 March 2009.
When looking at the differences between the estimated betas for increasing and falling stock markets, Danske notes the effect is strongest on the GBP crosses, although the EUR/GBP betas are very close to zero. However, GBP/USD has higher betas, and as the table shows, it tends to react stronger to a fall in stock markets than it does to an increase.
On the other hand, there is a significant difference in EUR/JPY, USD/CAD, EUR/CHF and EUR/SEK, as while the sensitivity to stock price movements is higher for EUR/JPY and EUR/CHF in an increasing market, the relation is stronger for GBP/USD, USD/CAD, and EUR/SEK in a declining stock market. Dankse thinks this is at least partly due to the recent waning of both the JPY’s and CHF’s safe-haven status.
This all helps to establish a good trading rule: be careful about applying market relations observed in one market to another. Or in other words, a bear market currency reaction is going to be different to a bull market currency relation.
With that in mind though, the table does help to identify good beta-trades. For example, notes Danske, a long AUD/JPY position is by far the best way to position for a stock market rally. On the other hand, both a short AUD/JPY and NZD/JPY – and maybe even a CAD/JPY position – could be a good choice in a falling stock market.
Looking at G4 currencies, notes Danske, a long EUR/JPY position is good in a rising stock market, while a short EUR/JPY or GBP/USD position is a better move in a falling market.
The bank notes the table also shows that the current strong relation between stock price movements and currency movements is most vulnerable for GBP/USD, USD/CAD, EUR/SEK, NZD/USD. That’s because these crosses all have significantly higher betas in falling stock markets. The likely cause of such a strong relation between FX and equity markets for these crosses is flows related to the financial crisis, says the bank. However, it notes these deleveraging flows are unlikely to continue to dominate the FX market.
In general, Danske believes the historically high correlations with the stock market are related to financial deleveraging. This leads it to then expect the equity correlation to decrease gradually through 2009 for most of the G10 currencies.
