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Saturday, August 13, 2022
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    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 financial 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.

    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 financial 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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