FAP Turbo 2.0 Blog

FAP Turbo 2.0 Blog: Currencies and Other Financial Markets

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).

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.

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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 U.S. 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.
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 U.S. equity
markets over the last five years.

The two markets occasionally intersect, though this is usually
only at the extremes and for very short periods. For example,
when equity market volatility reaches extraordinary levels
(say, the Standard & Poor’s 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.

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 a short-term basis. 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.

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
(interest rate differentials) exert a major influence on forex
markets.

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