EUR/JPY and EUR/USD correlation: following up despite the challenge of non-stationarity. Is USD joining JPY in the carry-trade currency club?

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Written by Forex Automaton   
Monday, 20 October 2008 15:38
Article Index
EUR/JPY and EUR/USD correlation: following up despite the challenge of non-stationarity. Is USD joining JPY in the carry-trade currency club?
Time history of covariance and correlation
Correlation peak structure
The role of LIBOR
All Pages

This is a follow-up to EUR/JPY and EUR/USD 2002-2008: intermarket correlations (leader-follower). In that note, I argued that statistically, the correlation peak seen in the time lag dependence of the correlation function, continued into negative lags so much that it's visible in the -1 hour bin, and possibly a couple of next ones. My tentative interpretation was that EUR/JPY, having a larger interest rate differential, was the leader and EUR/USD with a smaller interest rate differential, the follower, thus forming a predictable pair and a statistically significant trading opportunity on the hour scale. Obviously the difference in the interest rate differentials between EUR/JPY and EUR/USD is the same as the interest rate differential between USD and JPY. The issue of correlation between EUR/JPY and EUR/USD is the issue of correlation between JPY and USD, defined with respect to the common base currency, EUR. The response of the USD to the recent financial cataclysms, being not unlike that shown by the weaker yielder JPY, gives some credibility to the notion of USD being on the way to becoming the next carry-trade currency, regardless of how many bullets the Fed is left with. All of this, and a comment from a reader about EUR/JPY and EUR/USD correlation being presently much higher than historic average, motivated me to trace the correlation over the interesting range of time lags into the present, with particular attention to the time evolution of its shape and magnitude.

Executive summary

The intermarket correlation, of which a single value is commonly quoted, is a function of the time lag -- and obviously, time history. Two time periods with distinctly different behaviour of the correlation peak can be selected. The first, 2002-2004, is characterized by symmetric correlation with respect to the time lag sign flip and low USD-JPY interest rate differential. The second period started when the interest rate differential rose above 250 points, and the predictive correlation feature, the main subject of this report, belongs to this period. Thus the original interpretation, linking the shape of the correlation to the interest rate differential, is confirmed. If the expansionary monetary policy in the US continues, the obscure predictive forex inefficiency seen historically in the significant non-zero correlations between EUR/JPY and EUR/USD at negative time lags, will likely cease to exist, while the widely known zero-time lag correlation (of no predictive value per se) will likely stay high till the balance of future monetary policy adjustments in the US and Japan changes this state of affairs.

EUR/JPY chart, hour, 2002-2008 EUR/USD chart, hour, 2002-2008

Fig.1: Data used in the analysis, top chart: EUR/JPY, bottom: EUR/USD. Time period is from March 28, 2002 to October 16, 2008. Time axis is labeled in MM-YY format. Time scale is hour.

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