Correlation of foreign exchange and other financial markets

Predicting the next move in financial markets is the key to successful trading. Seasoned traders have long known that trading in the foreign exchange market requires looking beyond the Forex arena. Apart from macroeconomic events and economic releases, currencies are also moved by the performance of other financial instruments.

Knowing which currency is correlated with what market can enable a trader to spot specific market movements before they occur. Keeping a close watch on the instruments to monitor in order to stay ahead of the game and make more informed trading decisions.

Stock indices

A quick observation of stock indices can tell a lot about the market sentiment, which is highly helpful information for a trader. Market sentiment refers to how comfort a trader feels in relation to the market. The more confident he is, the greater his willingness to take risk. In general, stock indices go up when market sentiment is positive – also known as risk appetite – and decline when sentiment is negative – known as risk aversion.

When evaluating market sentiment, traders look at stock indices such as the Dow Jones Industrial Average, S&P 500 and Nasdaq 100 in the U.S., the FTSE 100 in the UK, the DAX 30 in Germany and the Nikkei 225 in Japan. An uptrend in a country’s stock index will have a positive impact on the economy’s growth, therefore triggering an increase of the national currency.

It is interesting to note that stock exchanges can only influence the Forex market during their 6-hour time of operation, while the most significant movement occurs at the opening of the session. Traders usually know ahead of time how the stock market is going to open, as corporations comprising the stock index regularly release news and economic data to the public. Positive data will increase the company’s stock price and therefore increase the value of the stock index as a whole. So, if let’s say, traders expect that the S&P 500 will be opening significantly higher during the U.S. trading session and the actual opening figures verify this, the greenback would be correspondingly strengthening its position in the currency market.

Currencies

During periods of economic growth, traders have a tendency to take on increased risk. When there is a positive market sentiment and stock indices rise, traders are more willing to buy higher yielding instruments, including currencies such as the:

• GBP
• EUR
• NZD
• AUD
• CAD

Demand for these higher yielding currencies typically leads to appreciation of their value against the lower yielding and safer ones, such as the:

• JPY
• USD
• CHF

Positive sentiment and risk appetite may put upward pressure on the USD, JPY and CHF currency pairs, like EUR/USD, GBP/USD, AUD/USD, GBP/JPY, AUD/JPY, EUR/CHF, GBP/CHF and AUD/CHF. On the contrary, when market sentiment is negative and stock indices drop, higher yielding and more risky currencies, such as the EUR, GBP, AUD, NZD and CAD, usually lose value. Risk aversion may result from downbeat economic data, geopolitical risk events or anything that would prevent traders from taking more risk. That is why traders should monitor all scheduled data releases pertinent to the currency pairs they are trading.

Gold

In times of market instability, gold acts as a safe haven and a hedge against inflation. As gold serves as a store of value with a great potential of surviving political and economic turmoil, the precious metal’s price tends to rise. Trading the Australian dollar is analogous to trading gold. Being one of the world’s largest gold producers, the aussie registered a 89% positive correlation with gold between 2000 and 2012. Put it simply, when the price of gold increases, the AUD also gains value. As gold is commonly traded against the USD, the two have an inverse correlation, meaning that higher gold prices generally result in a weaker US dollar and vice versa. When the US dollar loses value, it becomes cheaper to buy gold. Thus, AUD which is also correlated to gold rises.

Australia is the favoured country for exporting New Zealand goods, due to the closeness of the two countries. As a result, the strength of the economy of New Zealand is closely related to the strength of the economy of Australia, which justifies why the NZD/USD and the AUD/USD registered a 96% positive correlation between 1998 and 2008. The relationship of the NZD/USD pair with gold is also strong, recording a 78% over the same period. Another important correlation with gold is that of the Swiss franc. The country’s political impartiality and the fact that the franc used to be backed by gold have crowned the currency as the most favoured currency during periods of political uncertainty. It is notable that from 2006 to 2009, USD/CHF and gold prices had a 77% positive correlation.

Oil

As one of the world’s most essential necessities, the price of oil affects the currency values of the countries that are heavily reliant on it. Just like the Australian dollar is affected by the price of gold, the Canadian dollar, which is one of the largest oil exporters, tends to be affected by changes in oil prices. The loonie usually strengthens on increases in the price of oil and weakens when oil prices drop. The proximity between the US and Canada, along with the political instability in the Middle East have made Canada one of the most preferred destinations from which the US imports oil. The price of oil serves as a major indicator for the price performance of CAD/USD. If the traded pair is the inverse, it is historically proven that when oil prices rise USD/CAD goes down and when oil prices fall USD/CAD goes up.

At the other end of the spectrum, an increase in the price of oil would be a direct threat for countries like Japan that purchase almost their entire supply of oil. Japan’s lack of energy sources render it extremely susceptible to changes in oil prices. As more expensive oil imports become, the country’s overall price levels soar, leading to inflation and depreciation of the yen. On the opposite scenario, when oil price becomes cheaper, the currency gains strength.

One of the most attractive oil trades is CAD/JPY. Examining this from an oil exporter - importer point of view, this currency pair is at the top of the list of currencies to demonstrate the performance of oil prices, as there is a strong correlation between oil and CAD/JPY.

The bottom line

Being aware of the related markets affecting Forex can enable you comprehend and predict certain market movements, thus boosting your chances of success.