Correlation Between the Dollar and Fed Fund Futures

Includes: ERO, JYN, UDN, UUP
by: Kathy Lien

For currency traders, the most interesting article in today’s Wall Street Journal is the one about volatility in the financial markets causing trading relationships to be in flux.

This article examines some of the correlations that we talk about regularly, between USD/JPY and stocks or the EUR/USD and oil. The premise of this article is that these correlations may be fading, even though USD/JPY has traded in sync with the Dow today while the positive correlation between the EUR/USD and oil prices remain intact.

Correlations run hot and cold and even though the Wall Street Journal article may have a point, there will always be times when correlations are strong and weak.

The one correlation that has remained intact so far is between USD/JPY and the December Fed Fund futures contract. Since March, the correlation between these two assets has been more than 90 percent. This tells us that the US dollar has been trading almost entirely based upon the market’s expectations for the Federal Reserve moves this year. Back in March, USD/JPY plummeted below 100 when Fed fund futures priced in steeper rate cuts. By June, the greenback recovered impressively against the Yen as oil prices surged forcing Fed fund futures to price in the possibility of rate hike before the end of the year. Interestingly enough, the correlation between the December Fed fund futures contract and the EUR/USD has been approximately zero between March and July.

The reason why the correlation is strong for USD/JPY but nonexistent for the EUR/USD is simple; everyone knows that Japan can not alter interest rates despite their economic conditions while the outlook for Eurozone rates remains uncertain. In contrast, weaker conditions in Japan have already been priced into the market, but no one knows for sure if the Eurozone will skirt a recession or whether the European Central Bank will deliver another rate hike this year.