The Elusiveness of Currency Diversification

One challenge investors and portfolio managers is achieving diversification. Impressionistic views gained from every day experience are confirmed by a number of academic studies. Diversification in the international capital markets is becoming increasingly difficult. Bond markets have long been highly correlated. Equity markets have become increasingly so. Foreign exchange was embraced by some money managers as a way to regain diversification, long thought to be a key aspect of modern portfolio theory.

The foreign exchange market itself is becoming more correlated. In recent reports we noted that the euro's correlation to the US S&P 500 has never been greater, using daily correlations on a 30- and 60-day rolling basis. This is true going back before the euro was born in 1999, using the synthetic measure on Bloomberg. In this note we look at the euro's correlation with a handful of major and emerging market currencies. The main findings are:

1) Other foreign currencies are highly correlated with the euro and are increasing

2) That there have been some substantial swings in some pairs

Euro-Australian dollar: The 60-day correlation stands near 0.81. It has been briefly above here only a couple of times in the early 1990s. The 30-day correlation is just below 0.898, it was only higher in the in early 2004. The fact that the 30-day correlation is above the 60-day, indicates the correlation has increased in recent weeks.

Euro-Canadian dollar: The 60-day correlation is a little above 0.71. The high was just above 0.80. It reached those after the correlation had fallen to less than 0.16 in February. The 30-day correlation is slightly above the 60-day correlation. In early January, there had been an inverse correlation (-0.10).

Euro-British pound: The 60-day correlation peaked in August near 0.81. Now it is just below 0.68. The 30-day correlation is a touch higher at 0.70. It had reached a 3-year high in August near 0.88 before falling to 0.60 by late September.

Euro-Japanese yen: Before the financial crisis, the euro and yen were relatively highly correlated, often in the 0.70-0.80 area. Now the 60-day correlation is near 30, coming off from a mid-September higher near 0.42. As one of the exceptions to our generalization, the 30-day correlation is a touch lower, but it is rebounding from an inverse correlation (-0.33) in mid-October. In the March-May period, the euro and yen were also inversely correlated on a 30-day rolling basis. For currency diversification purposes, the yen was the best of the currencies we looked at.

Euro-Brazilian real: The euro and the Brazilian real are as correlated over the past 60 days as much as the euro and sterling (0.67). Historically this is still relatively high even though it reached a record above 0.81 in late July. The 30-day correlation is near the same level, having peaked near 0.85 in June. It is rebounding from a fall to 0.55.

Euro-Mexican peso: The euro's 60-day correlation with the Mexican peso is just below the real's at 0.61. It has only been above this area only a few times. In late July, it hit a record near 0.75. The 30-day correlation is near 0.67, about the same as real's correlation for the same period. It reached a record high near 0.85 in July before falling to 0.40, from where it its rebounding.

Euro-Singapore dollar: The euro's correlation with the Singapore dollar on a 60-day rolling basis stands at the high for the year, just below 0.80. It has rarely been above here. Since 2008, it hardly has been below 0.50. The 30-day correlation is a little above 0.85, which is also the highs for the year. In late 2009, the correlation briefly was near 0.90.

Euro-South African rand: The euro's 60-day correlation with the rand is about the same as its correlation with sterling and the real, near 0.67. In late July, it peaked near 0.83. The 30-day correlation is just below 0.77. It reached a peak near 0.84 in July, which was the highest since 2005, when the 30-day correlation was near 0.88.

Euro-Hungarian forint: Of this small set of currencies, the forint was the most correlated with the euro. The 60-day correlation stands at 0.89, which is at the upper end of where is has been. It did get up to 0.96 in 2005. The 30-day correlation is at 0.90. Back in 2005 it briefly near 0.98. The 30-day correlation has not been below 0.80 since Q1.