EUR/USD and GBP/JPY 2002-2008: Intermarket Correlations (Leader-Follower)

Euro/US Dollar and British Pound/Yen do not seem to share any investment themes. Nevertheless these are correlated currency pairs, with a hint of a leader-follower relationship.

Table: Pearson correlation coefficient for the time series of logarithmic returns in EUR/USD and USD/JPY in various trading sessions in 2002-2008.

time scale Asia-Pacific session European session American session

EUR/USD and USD/JPY are weakly correlated on average for the period. The correlation is the least pronounced in the American session.

EUR/USD and GBP/JPY intermarket correlation

Fig.1: Cross-correlation of EUR/USD and GBP/JPY, derived from the hour-by-hour logarithmic returns, for the three trading sessions.

The fact that most of the correlation is concentrated at the 0 lag means that the correlation (reported in the table) works out mostly on the time scale of up to 1 hour. The tail of positive correlation to the right of the 0 lag indicates that there is a “tail” of predictable action in EUR/USD lagging behind GBP/JPY. It is seen in the European and American sessions. To judge how reliable it is, one has to compare the signal with the noise level obtained from the martingale simulations.

EUR/USD and GBP/JPY intermarket correlation European session

Fig.2: Cross-correlation of EUR/USD and GBP/JPY, derived from the hour-by-hour logarithmic returns, for the European (Eurasian) trading session shown against the backdrop of statistical noise (red). The noise is obtained from martingale simulations based on the historical volatilities of EUR/USD and GBP/JPY in this particular trading session.

As Fig.2 demonstrates, the main challenge while working with trading session-specific correlations is the non-flat (although quite predictable) behaviour of the noise level with time lag. This can not be ignored otherwise one risks over-interpreting the picture. The area around zero is fairly safe since the noise is at the minimum when the lag is at an integer number of days. Based on the level of the noise, betting on EUR/USD following the lead of GBP/JPY seems to be a risky strategy. But if you decide to do that, the European or American session would be the best time.