As much as we like to think of the
forex market as the be-all and end-all of financial trading markets, it doesn't
exist in a vacuum. You may even have heard of some these other markets: gold, oil, stocks, and bonds.
There’s a fair amount of noise
and misinformation about the supposed interrelationship among these markets and
currencies or individual currency pairs. To be sure, you can always find a correlation
between two different markets over some period of time, even if it’s only zero
(meaning, the two markets aren’t correlated at all).
Be very careful about getting
caught up in the supposed correlations between the forex market and other
financial markets. Even when a high degree of correlation is found (meaning,
the two markets move in tandem or inversely to each other), it’s probably over
the long term (months or years) and offers little information about how the two
markets will correlate in the short term (minutes, hours, and days). Even worse,
what it may suggest about the short term relationship may be flat out wrong
and, therefore, dangerous.
The other point to consider is
that even if two markets have been correlated in some past period, you have no
guarantee that the correlation will continue to exist now or into the future.
For example, depending on when you survey gold and the U.S. dollar, which
supposedly have a strong negative correlation, you may find a correlation
coefficient of as much as -0.8 (a solidly negative correlation) or as low as
-0.2 (very close to a zero correlation, meaning that the two are virtually non-correlated).
Always keep in mind that all the various financial
markets are markets in their own right and function according to their own
internal dynamics based on data, news, positioning, and sentiment. Will markets
occasionally overlap and display varying degrees of correlation? Of course, and
it's always important to be aware of what's going on in other financial
markets. But it's also essential to view each market in its own perspective and
to trade each market individually.
With that rather lengthy disclaimer
in mind, let’s look at some of the other key financial markets and see what
conclusions we can draw for currency trading.
Gold
Gold is commonly viewed as a
hedge against inflation, an alternative to the US. dollar, and as a store of
value in times of economic or political uncertainty. Over the long term, the
relationship is mostly inverse, with a weaker USD generally accompanying a
higher gold price, and a stronger USD coming with a lower gold price. However,
in the short run, each market has its own dynamics and liquidity, which makes
short-term trading relationships generally tenuous.
Overall, the gold market is
significantly smaller than the forex market, so if we were gold traders, we’d
sooner keep an eye on what‘s happening to the dollar, rather than the other way
around. With that noted, extreme movements in gold prices tend to attract
currency traders’ attention and usually influence the dollar in a mostly inverse
fashion.
Oil
A lot of misinformation exists on
the Internet about the supposed relationship between oil and the USD or other
currencies, such as CAD or JPY. The idea is that, because some countries are
oil producers, their currencies are positively (or negatively) affected by
increases (or decreases) in the price of oil. If the country is an importer of oil
(and which countries aren’t today?), the theory goes, its currency will be hurt
(or helped) by higher (or lower) oil prices.
Correlation studies show no
appreciable relationships to that effect. Especially in the short run, which is
where most currency trading is focused. When there is a long-term relationship,
it’s as evident against the USD as much as, or more than, any individual
currency, whether an importer or exporter of black gold.
The best way to look at oil is as
an inflation input and as a limiting factor on overall economic growth. The
higher the price of oil, the higher inflation is likely to be and the slower an
economy is likely to grow. The lower the price of oil, the lower inflationary
pressures are likely (but not necessarily) to be. Because the United States is
a heavily energy-dependent economy and also intensely consumer-driven, the
United States typically stands to lose the most from higher oil prices and to
gain the most from lower oil prices. We like to factor changes in the price of
oil into our inflation and growth expectations, and then draw conclusions about
the course of the USD from them. Above all, oil is just one input among many.
Stocks
Stocks are microeconomic
securities, rising and falling in response to individual corporate results and
prospects, while currencies are essentially macroeconomic securities,
fluctuating in response to wider-ranging economic and political
developments. As such, there is little intuitive reason that stock markets
should be related to currencies. Long-term correlation studies bear this out, with correlation coefficients of essentially zero
between the major USD pairs and US equity
markets over the last five years.
The two markets occasionally
intersect, though this is usually only at the extremes and tor very
short-periods. For example, when equity market volatility reaches extraordinary
levels (say, the Standard & Poor’s [S&P] loses 2+ percent in a day),
the USD may experience more pressure than it otherwise would - but there's no
guarantee of that. The U.S. stock market may have dropped on an unexpected hike
in U.S. interest rates, while the USD may rally on the surprise move.
In another example, the Japanese
stock market is more likely to be influenced by the value of the JPY, due to the
importance of the export sector in the Japanese economy. A rapid rise in the
value of the JPY, which would make Japanese exports more expensive and lower the
value of foreign sales, may translate to a negative stock-market reaction on
the expectation of lower corporate sales and profitability.
Bonds
Fixed income or bond markets have
a more intuitive connection to the forex market because they’re both heavily
influenced by interest rate expectations. However, short-term market dynamics
of supply and demand interrupt most attempts to establish a viable link between
the two markets on short-term bags. Sometimes the forex market reacts first and
fastest depending on shifts in interest rate expectations. At other times, the
bond market more accurately reflects changes in interest rate expectations,
with the forex market later playing catch-up (because it takes longer to turn a
bigger ship around).
Overall, as currency traders, you
definitely need to keep an eye on the yields of the benchmark government bonds
of the major-currency countries to better monitor the expectations of the
interest rate market. Changes in relative interest rates exert a major
influence on forex markets.
