Many times, new traders look at correlations as reasons for taking trades. Unfortunately, correlations can lag or decouple and if you buy CAD, for example, just because Oil has gone up, you will have a hard time in your trading journey.
I took the Oil and CAD example because it’s one of the most famous correlations out there, but it’s also wrong. You may have learnt that CAD is correlated with Oil because Canada is a major Oil exporter, so the higher the price of Oil the more Canada earns and the better for its economy and currency.
Actually, Oil is correlated with the US Dollar (because most commodities are priced in USD) and the US Dollar is correlated with Global Growth. That’s right, Global Growth is what makes everything correlate. See below the charts of the correlation between USD/CAD and Oil, and DXY (USD Index) and Oil.
As you can see from the charts above the correlations are very similar, but you may say “there’s the USD on USD/CAD as well, so it’s not fair”. Let’s see then the correlation between AUD/CAD and Oil.
As you can see, when CAD appreciates, Oil depreciates. How is that? Well, it’s because of risk sentiment and the long-term risk sentiment is driven by Global Growth. AUD is particularly sensitive to risk sentiment, and it depreciates more compared to the CAD when there’s risk aversion.
So, how can you get a sense of where Global Growth is headed. The rule of thumb is watching US, China and Eurozone economies because they comprise more than half of Global GDP, but you can even just focus on the US economy which leads Global Growth. There’s a famous saying “when the US sneezes, the world catches a cold”. The US economy can single-handedly either boost Global Growth or drag it down.
As you can see from the chart above US PMI generally leads Global PMI. I took the PMI indicator because it’s a leading indicator for Growth (generally leads by 6-12 months). You can see below a chart of the correlation between US ISM Manufacturing PMI and US GDP.
You can experiment yourself by taking various charts and see how Growth moves everything. If you take the USD as a proxy for Glow Growth and compare it to other commodities or currency pairs, you will notice this correlation. Just note that, as we saw in a previous article about the USD Smile Theory, the US Dollar is inversely correlated with Global Growth, so when Growth accelerates the USD depreciates and when Growth slows down the USD appreciates. See the chart below with the US ISM Manufacturing PMI being inversely correlated with the USD.
So, this is your big picture, but as I mentioned in the beginning correlations can lag or decouple and that’s where you should be aware of what’s going on in the world and pair the short term with the long term.
For example, at the moment there’s a decoupling between the USD, bid as a safe haven because of Global Growth slowdown and the Russia-Ukraine crisis, and Oil, which is skyrocketing due supply disruption created by such crisis. In this case, it isn’t a good idea to short Oil just because of the bigger picture, because you would be fighting a strong momentum. Here comes the art of patience and waiting for the right opportunity to start fading everything once this hysteria in the Oil market starts to dwindle.
This article was written by Giuseppe Dellamotta.
