Correlations and trading

Correlation not causation. Ok, we've heard that thousands of time before. The difficulty is that we cannot simply ignore correlation if we are trading financial markets. The relationships between different assets and other data is often crucial to forecasting the market. If we were forced to ignore it, you'd end up ignoring so much data and instead be forced to look only at price data. Even with price data driven strategies such as trend following we are relying on some element of correlation (in this case autocorrelation within a time series).

There are many examples where we might use correlations in markets to come to a view. If the dollar has sold off significantly against most currencies expect one, is there a catch up trade there? If we can forecast one data point such as GDP or understand how central bank policy could change, how does that impact rates and FX more broadly? It's all about thinking about the chain of events, which are often linked, and how they impact each other. The crucial point is that we need to somehow ignore what might be spurious correlations. What can be equally puzzling, is when we are able to make an accurate forecast about one event, such as a data release, which has an intuitive relationship with the market, but the market simply ignores it. 

Earlier this week we saw an example when correlations suddenly moved in reverse to expectations in USD/JPY, which steamed higher, driven by fears around the Coronavirus on Japan, despite a general risk off tone to markets and a fall in yields. Traditionally, JPY tends to appreciate during risk off (ie. USD/JPY falls), on a safe haven effect, driven by several factors. These include the fact that JPY tends to be a funding currency and also because of spot being driven by longer dated USD/JPY vol instruments. Even for example during the Japanese earthquake, JPY appreciated significantly, and USD/JPY reached record lows.

So what do you do if the correlations go out of whack, which your trading strategy or approach uses? The first thing to do is to understand...

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