Correlation EUR/USD, USD/CHF, EUR/CHF (Humour me please... Thx)

Hey guys, I know this has been discussed long before. But in light of SNB's intervention in 6 Sep 11 and now the recent volatility because of the changeover in SNB's leadership, do you mind discussing this topic a little more with me?

So classically, we always assume that EUR/USD goes up, USD/CHF goes down. The inverse relationship is strong. Hence, in this case, Eur strengthens, dollar weakens and CHF strengthens. Hence, Eur and Chf is going in the same direction and their "price ratio" aka Eur/Chf remains fairly stable.

1) First question, have we confused correlation with causality? To be more specific, the strong correlation btwn EUR/USD and USD/CHF does naturally serve as a strong proxy to the price action of Eur/Chf. But, using this "correlation" as the main factor in our analysis of Eur/Chf might be a bit presumptious?

The reason why this becomes increasingly important is becasue of the well known 1.2000 peg that seems to have made markets less free, and a bit "unnatural" This leads to my second question,

2) Is there a need to change our paradigm and look at things a little differently. For example, we might like to think of price action of Eur/Usd and Eur/ Chf as those that influence Usd/Chf, instead of the classic relationship as mentioned earlier. Hence, although we still assume the same correlation, the causality chain becomes different.

Please tell me what you think. Appreciate it loads. Thanks!

HG,

Not sure if I'm answering your questions, as I use a strength indy (see screenshot) as my proxy for macroeconomics — I am too lazy to study fundamentals — and in that context I focus on currencies rather than pairs.

My observations are as follows:

CHF and EUR were traditionally very positively correlated, i.e. your comment about USDCHF being a mirror image of EURUSD confirm my views. The RS indy plots of positively correlated currencies tend to move in unison. However, throughout the majority of 2011 CHF became far-and-away the strongest currency (reflected by the steep rise in the yellow line on the monthly plot), and cascading sells on USDCHF would have provided easy gains. However, a cataclysmic shift took place around 10/11 Aug (SNB intervention?) which has resulted in a complete turnaround for CHF. CHF and EUR are currently the weakest currencies on all of the daily/weekly/monthly plots, although they don't move in unison to the same extent as previously. Hence my guess is that the underlying economic reasons (whatever they might be) have shifted, and I don't expect to see the same degree of correlation returning. That's my best attempt to answer your question (2).

As an example of strong positive correlation, look at AUD and NZD on the daily and weekly plots. This is frequently typical for these currencies. USD and JPY frequently go through periods of strong positive correlation also. Pairing positively correlated currencies results in a sideways moving charts, with overlapping, long-wicked candles. To address your question (1), then, when EUR and CHF were strongly positively correlated, the EURUSD and USDCHF were near perfect mirror images, and (due to the triangular equilibrium that must be maintained, viz. EUR/USD x USD/CHF = EUR/CHF), the EURCHF chart frequently moved sideways. [EDIT: see second screenshot]

Just my 2c. Correlation is an important ingredient in my trading strategy: pairing negatively correlated currencies creates the strongest, smoothest trends, the perfect adjunct to a trend-following strategy.

David

Footnote: You might find this article interesting.

eur/usd is most of the time negatively correlated to usdchf because eur and chf tend to have similar trends. But you already know that. Whats important however is that chf is not the euro, meaning that trends can and will be different as you have seen yourself. So even though most of the time they are correlated, things can and will change. So I would not bet on eur(usd) / (eur)chf correlations, but check out how euro and chf are doing against several currencies to see how they are trending (or not) overall. To make a long story short: dont try to analyze correlations between pairs, but try to analyse baskets (one currency against a basket of currencies) instead, to see what the real trend of a currency is... this is way more meaningful. hope that helped a bit.. p.s. hanover I'm a big fan of your programs!

Due to the CHF peg to the EUR there are now essentially two EUR/USD contracts. EUR/USD and a smoothed and inverted EUR (USD/CHF). GBP is also linked to the EUR but the band is wider so it isn't quite so noticeable on the shorter term when comparing EUR/USD and GBP/USD. EUR CHF and GBP form the European bloc.

The counter balance is the USD and JPY due to the implicit JPY central bank pegging to the USD. The European bloc of currencies generally trade opposite the USD - JPY bloc.

Rounding out the majors are the "independents": AUD, NZD and CAD.

These pegs are valid until they break or shift. They will break or shift at some point so plan accordingly.

EUR/USD rebounded further to as high as 1.2985 earlier today before retreating. With 1.2838 minor support intact, rebound from 1.2625 short term bottom is expected to continue to 1.3076 resistance and above

Near term focus in USD/CHF remains on 0.9304 support. As noted before, sustained break there will confirm topping at 0.9594, on bearish divergence condition in 4 hours MACD and daily MACD

the majors in forex are

eur/usd, gbp/usd,aud/usd some argue NZD/usd

usd/jpy,usd/chf, usd/jpy

the only other pair that does not involve the USD is eur/jpy

eur/chf

is eur/usd vs usd/chf.........having said that, the chf is synthetically made so you might one to research synthetic pairs.

the floor props up the eur as weakening puts downward pressure on the CHF the EZ trading partner.

creating demand for euros and selling CHF open market will create appreciation of euros vs usd and relative weakening of CHF vs usd.

USD/CHF


Daily Pivots: (S1) 0.9435; (P) 0.9505; (R1) 0.9562

The point in bold is a mistaken assumption in a complex system. It is like saying, USD Index goes up -->AUD/USD goes down.

If you would like to ad the classic economic assumption of certis peribus or, all else being equal than the above bold section is true by deifinition.