From the point of view of two-point correlation analysis, the Euro/Pound Sterling exchange rate shows patterns which look similar to EUR/AUD.
During the period we consider (2002-2008), the BOE’s official bank rate was between 3.5 and 5.75% while the ECB’s key interest rate went from 2.25 to 3%.
The basic autocorrelation
As before we employ autocorrelation as a straightforward, inter-disciplinary, non-proprietary technique to test market efficiency in the EUR/GBP market. In Fig.1 we look for features on the time scale of up to 100 hours such as to suit the time scale of day trading or swing trading. The hatched red band shows the range of statistical noise (namely its expectation plus minus its RMS deviation). Statistical noise was obtained by simulating 20 independent time series of the length corresponding to that of the EUR/GBP series, each one constructed to reproduce the measured distribution of returns for the time period under study, but constructed to be free of correlations (the so-called martingale time series). From these, the expectation and RMS or the autocorrelation amplitude in each time lag bin were calculated.
The one-hour time lag “contrarian” feature (a significant anticorrelation) we saw in this type of plot for other currency pairs involving GBP ( GBP/JPY ) and EUR ( EUR/AUD, EUR/CHF ) is quite strong in the EUR/GBP autocorrelation. Moreover the width of the anticorrelation deep is not limited to just one time bin — the effect has a larger correlation length than usually seen. The autocorrelation being an average of a product of hourly returns taken with a lag, its negativity means that we are way too frequently (more frequently than in the corresponding martingale time series) taking a product of opposite sign returns for this time lag— or that the product of the opposite sign returns by far outweighs that of the same sign returns for this time lag. Because trend reversals on the time scale of about one hour happen either too often or are too lucrative, EUR/GBP, like EUR/CHF, EUR/AUD, GBP/JPY, AUD/USD and AUD/JPY analyzed before, may well be the market where winning strategy requires being a contrarian on a short time scale.
Like EUR/CHF, EUR/GBP is the currency pair where the martingale simulation “prescribes” an overall positive correlation. Its visibility is underscored by the overall relatively low volatility of EUR/GBP with consequently tighter noise range (width of the red band in the figures). As seen best in Fig.2, the autocorrelation for the lag ranges we have probed is inconsistent with such a “prescription”. Therefore, short range dynamics of EUR/GBP is quite different from what is prescribed by its long term “investment theme”. As always, one should not trade this pair short-range on the basis of long-range considerations alone.
24-hour trading cycle.
Next we split the full time series into “bullish” and “bearish” samples to examine correlations within those — in hope that this provides better insights into the mechanisms of decision making and trader psychology. These samples are simply sets of hourly time intervals (not necessarily contiguous) with an upward or downward trend. In Fig.3 we construct autocorrelations of the subsamples of the full time series (the “bullish” and “bearish” ones) selected by taking only positive and negative returns respectively. The 24 hour cycle of bullish and bearish action is again clearly seen as the maxima of the correlation are located at multiples of the 24 hour lag: 24, 48, 72, 96, 120 hours and so on. Therefore, smart trend following means something more than following a trend that existed in the near past. It means following a trend that existed this time of the day yesterday, the day before yesterday, and so on — that gives you better than average chance of winning! Conversely, buying because the currency went up 12 hours ago (or selling because it went down 12 hours ago), all the rest being equal, is the least recommended strategy. (See why this 24-hour correlation feature alone is not a prediction strategy. ) Needless to say, this effect is not present in the simulated martingale data, although bullish and bearish trends and rallies occur there as well.
Note that whether this trend following pattern in all time zones is equally strong is a question that requires a separate study.
Similar patterns have been seen before with most other currency pairs in this series of predictability reviews. It is interesting to note that typically, the “bearish” correlation has a higher amplitude whenever the base currency is the currency with a higher interest rate. This has been seen with AUD/USD, AUD/JPY, USD/JPY, GBP/JPY, USD/CAD, (although the interest rate differential has not been that high, it is in favor of USD), AUD/USD, CHF/JPY, and EUR/CHF.
In case of EUR/AUD, and now EUR/GBP, where the quote currency has a higher interest rate, the “bullish” correlation has a higher amplitude. Obviously this is the manifestations of the same effect: selling of a higher yild currency tends to be more predictable.
The fact that one can read the sign of interest rate differential off the public forex quotes via basic correlation analysis indeed goes against the efficient market dogma as it indicates that despite large liquidity such interest rate differentials are not completely discounted by the markets and there remain profit opportunities for algorithmic trading.
The EUR/GBP currency pair has been showing a “contrarian” trend reversal tendency in addition to the trend repetition signal with a 24-hour-multiple time lag seen in most other currency pairs. Like many other currency pairs we inspected, EUR/GBP is not completely “efficient” from the point of view of basic two-point correlation analysis. Long term prospects of EUR/GBP are the subject of fundamental analysis and are outside the scope of this article. Cross-correlations with other markets are to be discussed in the up-coming articles. In this report we used data for the period from 00:00 2002-08-20 to 00:00 2008-02-01 (New York time).