Successful forex trading isn’t just about analyzing multiple currency pairs and correlations. It’s important to think beyond and broaden your focus on intermarket forex correlations like how commodities like Gold, Crude oil, Bonds, and Equities markets affect the forex market. Join me as I cover three crucial forex correlations and how you can leverage them to your advantage in forex trading!
Intermarket Correlations & Forex Trading: An Introduction
Intermarket correlations are the connections and relationships between different financial markets. With regard to forex trading, correlations between markets are of particular importance since commodities, stocks, and bonds are tightly linked to the foreign exchange market.
Intermarket correlations come in two basic types, including:
- Positive Correlation: A positive correlation is observed when two markets show movement in the same direction. (For example, due to Australia’s significant gold production, an increase in gold prices can increase the Australian dollar).
- Negative Correlation: A negative correlation is what happens when two markets move in opposite directions. (For example, during times of high oil prices, the Japanese yen, a safe-haven currency, may lose value.)
While it is true that a currency fluctuates based on supply and demand characteristics, this fundamental principle is influenced by many factors that result in everyday currency fluctuations. By analyzing intermarket forex correlations, traders can formulate intricate trading strategies that incorporate a variety of factors beyond currency values.
What is a Correlation Coefficient?
A correlation coefficient is a statistical measure that indicates the degree of association or relationship between two securities. It measures the degree to which two securities are linearly related and in what direction. It is denoted by the symbol “r” and ranges from -1 to +1, where -1 indicates a perfectly negative correlation, 0 indicates no correlation, and +1 indicates a perfectly positive correlation.
Stocks & Forex Correlations: Impact of Stocks on Forex Rates
Although the foreign exchange (forex) and stock markets are distinct financial markets, they can exhibit correlated movements, which may not be immediately obvious to the untrained observer.
Theoretically, if a nation’s economy and stock market outperform those of other countries, its currency should experience a rise in demand compared to other national currencies. Conversely, if a country’s economy and stock market perform poorly, its currency will be in lower demand and subsequently decrease relative to other currencies. However, several practical factors influence whether a substantial correlation exists between the stock and forex markets.
What is the Correlation between Stocks and Forex?
Typically, dollar-based currency pairs demonstrate a positive correlation with the broader U.S. stock market. This means that when the U.S. dollar strengthens, the U.S. stock market generally rises, and when the dollar weakens, the market tends to decline. This correlation is often viewed as an indication of the robustness of the U.S. economy.
However, certain exceptions may exist, particularly with narrow blue-chip indices such as the Dow Jones Industrial Average (DJIA). Most large publicly traded U.S. corporations that make up this index conduct significant amounts of business outside the U.S. As a result, fluctuations in the value of the U.S. dollar can significantly affect their bottom line.
When the U.S. dollar is strong, these companies’ profits from their foreign operations often decrease, leading to a negative impact on the price of their stock. Therefore, even though a correlation may exist, stocks of this type may exhibit a weak or negative correlation with the dollar, which may not generate a dependable trading signal.
On the other hand, some market indices may demonstrate a more robust correlation with specific currency pairs. For example, the broad S&P 500 stock index and the USD/JPY currency pair may exhibit a stronger correlation.
How to Take Advantage of Stocks and Forex Correlations?
Selecting a stock for trading or investment is influenced by market conditions and the nature of the company’s business. Moreover, conducting a comprehensive fundamental analysis of the stock and its underlying company can reveal the level of foreign exchange exposure and the methods employed to mitigate this risk.
The extent of exposure a company has in each national currency can even determine its profitability in that region. Typically, when the U.S. dollar is trending higher, a U.S.-based multinational company would be better off hedging its foreign income. Conversely, the corporation may benefit from remaining unhedged in a declining dollar environment.
For instance, consider the case of a major corporation such as Procter & Gamble Co. (NYSE: PG) to illustrate how forex rates can impact its stock price. A strong euro and a weak dollar environment generally favor P&G's stock price because the company manufactures most of its products in the U.S. This positive correlation results from the sales of those products in the European Union (EU) for euros that provide a larger U.S. dollar return when those euros are sold or translated back into P&G's domestic currency.
Additionally, P&G’s main competitors are Nestlé S.A. (OTC: NSRGY) and Unilever plc (NYSE: UL), both of which are based in Switzerland and the United Kingdom, respectively. These companies produce many of their products in the EU and the UK, which makes their products more expensive to manufacture and gives P&G a competitive edge when selling its U.S.-made products in the EU.
On the other hand, a strong U.S. dollar would benefit P&G’s competitors and negatively impact P&G’s bottom line. This is because P&G’s products would cost more to manufacture in the U.S., making them less competitive abroad. Additionally, the euros received for its products would be worth fewer dollars in a weaker euro environment.
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Commodities & Forex Correlations: How Commodities Affect Forex
Commodities and currencies are interrelated around the world, but situations can change, and the relationships are fluid. It is worth noting, however, that some time-tested relationships have endured well into the 21st century. Here are a few reliable correlations between commodities and currencies.
Positive correlation between Gold and AUD/USD
Australia is the world’s third largest gold producer, exporting around $5 billion worth of gold annually. The strong historical correlation between the price of gold and AUD/USD remains stable, as Australia is the second largest gold producing country and the Aussie is considered a “commodity currency.” The correlation between gold and AUD/USD is positive, with an 80% historical correlation, meaning that when gold prices rise, AUD/USD tends to rise as well, and vice versa.
Role of Gold in Swiss Franc Strength
Due to Switzerland’s significant gold reserves, which make up more than 25% of its currency reserves, the CHF has a strong correlation with gold. Whenever the value of gold goes up, the demand for Swiss gold reserves increases, resulting in an increase in the value of CHF. Conversely, a decrease in the value of gold can lead to a decline in the value of CHF as demand for the currency decreases. Additionally, the Swiss National Bank’s decision to increase or decrease the supply of CHF can also influence its value.
Silver and the AUD/USD
Within trading circles, the commonly held belief is that the Australian Dollar/US Dollar (AUD/USD) has the strongest correlation with gold. However, recent findings suggest that silver may in fact be a more reliable indicator. It is widely known that mining plays a significant role in the Australian economy, with over 2% of the workforce and 5% of the GDP being dependent on it. Furthermore, mining contributes approximately 35% of Australia’s exports, making fluctuations in the metal market highly influential in shaping the outlook for the AUD.
West Texas Intermediate Crude Oil and USD/CAD
West Texas Intermediate, or WTI, is the primary type of oil traded in North America, and it contributes significantly to the Canadian economy. While it is common knowledge that the United States is the world’s largest consumer of oil, with a daily consumption of almost 19 million barrels, a misconception exists regarding the country’s primary source of oil imports.
While many people assume that Saudi Arabia is the largest supplier, in reality, Canada is responsible for one-third of the oil imports, with Saudi Arabia contributing just over 17%. The US produces around 10 million bpd of oil domestically, but due to Canada’s extensive oil exports to its larger neighbor, the value of the Canadian dollar is closely tied to the price of this crucial commodity.
Read top crude oil trading tips and strategies to learn how to leverage the world’s primary energy source!
Oil’s Impact on the Canadian Dollar and Japanese Yen
Oil is considered to be a crucial commodity for sustaining the needs of modern society. Presently, it is difficult for individuals in developed nations to imagine living without it. As a net exporter of oil, Canada experiences significant negative impacts because of declines in oil prices, while Japan, which is a substantial net importer of oil, tends to benefit from these declines. Consequently, fluctuations in oil prices can influence both the Canadian dollar (CAD) and the Japanese yen (JPY).
When the price of oil rises, the value of the CAD typically increases while the JPY tends to decrease, and vice versa. Although the correlation between oil and the Canadian dollar may break on a day-to-day basis, over the long run, it has proven to be strong because the value of the Canadian dollar is heavily influenced by oil prices. Canada is ranked as the fifth-largest crude oil producer in the world, with the third-largest oil reserves.
Brent Crude Oil and USD/NOK
Brent Crude Oil originates from the North Sea and is traded predominantly in Europe. Various countries have access to the North Sea’s oil, but the Norwegian section is estimated to hold around 54% of its oil reserves. Consequently, Norway’s economy is significantly impacted by the price of Brent crude. Norway ranks as the fifth-largest oil exporter and third-largest gas exporter globally, with these industries contributing over 20% to the country’s GDP.
Although the correlations discussed are reliable in the early 21st century, they are not the only ones that exist. As the global landscape changes, new industries may arise, and old ones may fade. For example, oil reserves may only last until 2040, and Bolivia’s lithium reserves could make it the next Saudi Arabia. Therefore, it is important to remain vigilant for emerging correlations as industries evolve over time.
Trading Commodity vs Forex Correlations
Commodity traders speculate on the future value of a commodity. When traders predict an increase in the commodity’s price, they will purchase futures, known as ‘going long.’ Conversely, if they anticipate a decrease in the commodity’s price, they will sell futures, referred to as ‘going short.’ Physical trading of commodities is also an option for those interested in acquiring assets like gold or other precious metals. However, it may not be feasible for other commodities.
This article elaborates on the impact of currency and commodity correlations on the broader movements of forex prices.
Bonds & Forex Correlations: How Bonds Influence Currency Prices
Bonds are fixed-income debt securities issued by governments, large companies, and multinational organizations to borrow funds at a fixed rate on their principal. The bond market is considered crucial in the financial system as it helps these organizations raise funds and is vital for government financing.
The bond market and the foreign exchange market are strongly correlated, with the bond market often indicating Forex currency movements and vice versa. Thus, monitoring government bond prices (or yields) is essential to predict price movements in the currency market.
What Are Bond Yields?
The bond price represents the amount of money a bondholder pays for the bond, while the bond yield is the interest paid to the bondholder upon maturity. It is worth noting that bond prices and bond yields have an inverse relationship. When bond prices increase, bond yields decrease, and when bond prices decrease, bond yields increase.
Suppose you own a government bond. By purchasing a bond, you are essentially lending money to the government, with a predetermined maturity date for repayment. The bond yield represents the rate of return, also known as coupon payments, that you will receive at certain intervals. It is important to note that the forex market is connected to the government bond market, rather than the corporate bond market.
The bond yield for a government bond is the interest rate set by the nation’s central bank that the government is willing to pay for borrowing money. Generally, government bonds are considered a safe investment and therefore tend to have lower yields. However, this may vary depending on the country. For instance, lending money to a stable and developed country like the United States will result in a lower bond yield compared to lending money to a less stable country like Argentina (with 1.41% and 51.71% bond yields respectively, according to Statista).
Correlations between Stocks, Bonds, and the Forex Market
Bond yields indicate the strength of a country’s stock market, which affects demand for its currency. For example, US bond yields reflect the demand for USD. In times of stock market uncertainty, demand for bonds and the safe-haven USD increases, pushing their prices up. However, if bond yields decline due to a falling stock market, demand for the country’s bonds and currency may decrease. Central banks may lower interest rates to encourage spending during economic slowdowns, but investors may sell the currency until rates are raised again. Understanding market sentiment is crucial in determining the current scenario.
What Are Bond Spreads and How Does it Affect Currency Rates?
Bond spreads refer to the difference in bond yields between two countries, and they are used to monitor interest rate differentials. This helps traders predict the direction of currency pairs using the carry trade strategy. When a bond yield is higher than other assets, investors buy the bonds, and thus the local currency.
Bond yields and currency exchange rates move in the same direction, and they are influenced by a country’s monetary policy and interest rate expectations. Economic data and central bank policies are important to follow as bond yields fluctuate with interest rate expectations and market sentiment.
The researchers computed correlation coefficients and presented them in a “correlation matrix”, which involved calculating correlations between each asset and every other asset. Their study, conducted from September 2015 to December 2017, found negligible correlations between leading fiat currencies and a variety of crypto pairs.
The correlation calculations were performed for all pairs, including fiat pairs, against each other. As expected, many fiat currencies were strongly correlated with one another, such as the Euro and Swiss Franc, which had an 82% correlation due to Switzerland’s trade with the Euro Zone.
Only the Japanese Yen and British Pound showed no significant correlation, making them popular safe-haven currencies. The most intriguing finding, however, was the minimal correlation between cryptocurrency pairs and traditional fiat currencies. There was a slight inverse relationship between Bitcoin and CAD/GBP, but it was weak statistically.
Crypto vs. Crypto Correlation
The study reveals the correlation between various cryptocurrency pairs, which may not come as a surprise to those who closely follow the cryptocurrency markets. Among the pairs, Ripple (XRP) and Stellar Lumens (XLM) have the highest correlation of 53.4%, likely due to the similarities between the two coins as they both strive to be a payment solution despite targeting different end users.
Additionally, there is a high correlation between Bitcoin and Ethereum, even though the underlying technology of these cryptocurrencies is significantly different. This correlation is observed in both the extreme lower quintile and median dependence.
How to Use Forex Correlations to Your Advantage?
It is crucial for traders to understand how market volatility affects their forex portfolio. This is due to the fact that currency pairs are interconnected, and no single pair trades independently of the others. By identifying these correlations and tracking their fluctuations, traders can effectively manage their portfolio’s overall exposure.
To calculate correlations, traders can follow these steps:
- To analyze currency pairs, select the ones you want to examine, such as EUR/USD and GBP/USD. Then, gather historical data for each pair, using daily, weekly, or monthly prices depending on your analysis needs. Calculate the returns for each currency pair over the chosen period by determining the percentage changes in price over time.
- Use a statistical tool or software to calculate the correlation coefficient between the returns of the two currency pairs. A positive correlation coefficient means the currency pairs move in the same direction, while a negative correlation coefficient indicates they move in opposite directions.
- Once you have the correlation coefficient, interpret it. A coefficient of 1 suggests a perfect positive correlation, -1 shows a perfect negative correlation, and 0 indicates no correlation between the two currency pairs.
Although correlations can change over time, it is not necessary to update them every day. Updating them once every few weeks or at least once a month is typically sufficient.
Forex Correlations Can Change!
Correlations between currency pairs can change rapidly, making it essential to track and understand their shifts. Short-term correlations may not reflect long-term trends, so it’s important to examine trailing correlations over six months. Factors such as monetary policy, commodity prices, and economic and political conditions can all impact correlations. Therefore, staying up to date with these factors is crucial to understanding currency pair correlations.
Learn how to adapt to changing Forex market conditions effectively!
How to Use Correlations to Trade Forex?
To use correlations to your advantage, consider avoiding positions that cancel each other out. For example, EUR/USD and USD/CHF move in opposite directions, so holding long positions in both would be the same as having no position. On the other hand, holding long positions in EUR/USD and AUD/USD or NZD/USD is like doubling up on the same position due to their strong correlations.
Diversification is also important to consider. For instance, using EUR/USD and AUD/USD to diversify risk while maintaining a core directional view is possible due to their imperfect correlation. Central banks of different countries have different monetary policy biases, so the impact of a dollar rally on each currency may differ.
Traders can also use different pip or point values to their advantage. For example, using USD/CHF to hedge EUR/USD exposure is possible because their near-perfect negative correlation allows for hedging.