No market exists in isolation. Stocks, bonds, currencies, and commodities are interconnected in complex ways. Understanding these correlations helps you anticipate market moves, manage risk through diversification, and identify trading opportunities. This guide explains the key relationships every trader should know.
What is Market Correlation?
Correlation measures how two assets move in relation to each other. It ranges from +1 (perfect positive correlation, they move together) to -1 (perfect negative correlation, they move opposite). A correlation of 0 means no relationship.
Key insight: Correlations are not static. They change over time and can flip dramatically during market stress. A relationship that holds during calm periods may break down during crises. Always verify correlations are holding before relying on them.
Major Market Correlations
Stocks and Bonds
The stock-bond correlation is one of the most important relationships in finance. Traditionally, stocks and bonds have negative correlation, making bonds a good hedge for stock portfolios.
- Risk-off periods: Stocks fall, bonds rise as investors seek safety
- Risk-on periods: Stocks rise, bonds may fall or stay flat
- Recent changes: In high-inflation environments, both can fall together
US Dollar and Commodities
Commodities priced in dollars (gold, oil, copper) typically show inverse correlation with dollar strength. When the dollar rises, it takes fewer dollars to buy the same amount of commodity.
Example: Dollar-Gold Correlation
The DXY rises 2% over a week:
- Gold typically falls as dollar strength makes it more expensive for foreign buyers
- Historical correlation: approximately -0.4 to -0.6
- Trading implication: Strong dollar often means weak gold
- Exception: During extreme fear, both can rise together (flight to safety)
US Stocks and International Markets
Global equity markets have become increasingly correlated, especially during crises. The US market often leads, with international markets following.
- S&P 500 and DAX: High positive correlation (0.7-0.9)
- S&P 500 and Nikkei: Moderate positive correlation (0.5-0.7)
- S&P 500 and Emerging Markets: Variable, higher during risk-off
VIX and S&P 500
The VIX (fear index) has strong negative correlation with the S&P 500. When stocks fall sharply, the VIX spikes. This relationship is one of the most reliable in markets.
Currency Correlations
Currency pairs show consistent correlation patterns:
Positive Correlations
- EUR/USD and GBP/USD: Both move against the dollar
- AUD/USD and NZD/USD: Both commodity currencies
- EUR/USD and Gold: Both typically inverse to dollar
Negative Correlations
- EUR/USD and USD/CHF: Nearly perfect inverse
- USD/JPY and Gold: Yen and gold both safe havens
Warning: Trading highly correlated positions doubles your risk, not your diversification. If you are long EUR/USD and long GBP/USD, you essentially have a double position against the dollar.
Correlation Trading Strategies
Strategy 1: Pairs Trading
When two correlated assets diverge from their normal relationship, trade the expectation of convergence. Go long the underperformer and short the outperformer.
Example: Pairs Trade
Gold and silver historically trade at a 60:1 ratio:
- Ratio expands to 80:1 (gold expensive relative to silver)
- Buy silver, short gold in equal dollar amounts
- Profit when ratio reverts toward 60:1
- Risk: Ratio can expand further before reverting
Strategy 2: Confirmation Trading
Use correlated assets to confirm trade signals. If you see a buy signal in the S&P 500, check if the DAX and global markets confirm the strength.
Strategy 3: Lead-Lag Trading
Some assets lead others. Copper often leads economic data. Bond yields often lead stock movements. Identify leading indicators for your markets.
Strategy 4: Diversification
Build portfolios with low or negative correlations to reduce overall risk. True diversification requires uncorrelated assets, not just different assets.
Sector Correlations
Within the stock market, sector correlations vary:
- Tech and Growth: High positive correlation
- Utilities and Bonds: Positive correlation (both rate-sensitive)
- Energy and Oil: Strong positive correlation
- Financials and Yield Curve: Banks benefit from steeper curves
- Consumer Staples and Discretionary: Low correlation (defensive vs cyclical)
How Correlations Change
Correlations are dynamic. Key factors that cause correlation changes:
Market Regime
Bull markets, bear markets, and ranging markets show different correlation patterns. Crisis periods typically see correlations spike toward +1 as "everything sells off together."
Monetary Policy
Federal Reserve actions can alter correlations. Quantitative easing changed the traditional stock-bond relationship for years.
Inflation Environment
High inflation can cause stocks and bonds to correlate positively (both falling), breaking the traditional diversification benefit.
Example: Correlation Breakdown
2022 showed how correlations can change:
- Stocks fell significantly (S&P 500 down ~20%)
- Bonds also fell significantly (AGG down ~13%)
- Traditional 60/40 portfolio offered no protection
- Cause: Rising rates hurt both asset classes
Tools for Monitoring Correlations
Track correlations with these approaches:
- Correlation matrices: View multiple asset relationships at once
- Rolling correlations: See how relationships change over time
- Scatter plots: Visualize the strength of relationships
- Intermarket charts: Overlay multiple assets to spot divergences
Common Correlation Mistakes
- Assuming stability: Correlations change, especially during stress
- Confusing correlation and causation: Correlation does not mean one asset causes the other to move
- Ignoring timeframes: Correlations differ on daily vs weekly vs monthly timeframes
- Over-relying on historical data: Past correlations may not predict future relationships
- Double exposure: Trading correlated assets doubles risk, not opportunity
Analyze Your Portfolio Correlations
Pro Trader Dashboard helps you understand how your positions relate to each other. Identify unintended correlations and build more resilient portfolios.
Summary
Understanding market correlations is essential for managing risk and finding opportunities. Key relationships like stocks-bonds, dollar-commodities, and equity market interconnections provide valuable context for your trades. Remember that correlations change over time and can break down during stress. Use correlation analysis as one tool among many, always confirming that historical relationships still hold before acting on them.
Ready to learn more? Check out our guides on dollar index trading and geopolitical risk trading.