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December 17, 2018

Correlations of Forex Currency pairs and other markets

Find out how financial markets affect each other and changes the prices.

Fundamental Economic News moves the Forex Market Prices.

To know the movement of markets, you must know the correlations of financial markets.

The subject of Technical Analysis will be greatly expanded upon in a dedicated chapter of its own.

However this trading method warrants a mention here due to the impact of fundamental news flow on the price action.

Through the application of Technical Analysis a trader is able, with a degree of certainty, to predict the possible direction of the price action or the market conditions that will follow.

A technical trader can do this by monitoring historical price action and then by employing Technical Analysis to expand his view into the future.

This can happen through the identification of certain relevant price points such as support and resistance levels.

Or the formulation of a trading plan around certain well known and identifiable market patterns such as double tops, double, bottoms, converging triangles, head and shoulders patterns.

The techniques that can be applied to technical trading are endless with individual traders constantly looking for an edge; hoping that this will give them a winning strategy.

However all technical studies, no matter how robust, cannot stand in the way of strong market news that can drive the market in one direction or another.

For examples

A trader may have a technical view to sell EURUSD on pull backs to the 8 period daily moving averages.

This method maybe profitable however on a given Friday once a month the Bureau of Labor Statistics announce the monthly United State Non-Farm Payrolls Number.

If in this instance the NFP number falls below expectations the US Dollar would weaken and therefore invalidate a shorting strategy for EURUSD.

Ultimately the price action may send EURUSD lower.

However market volatility during news releases can cause problems when entering the market.

For this reason it is only logical that a technical trader would be aware of pending news releases and would consequently prepare a trading plan in such a way to allow for the resulting market volatility.

Many Online Forex brokers offers the solution for the need for their clients to always be informed.

To this end they offer to all its clients, an economic calendar, live news feeds, forex calculators and up to date market analysis.

Forex Cross Currencies are all Connected -Sentiment Indicators-

The global market cannot be neatly separated into Forex, Equities, Commodities, Bonds and Metals.

There are relationships and correlation’s between all these markets.

At some points in time these relationships become stronger and at other times the relationships become detached.

As a trader, it is important to view the markets as a living organism that has mood swings that shift from depression to euphoria in a short space of time.

These market mood swings can be termed as market sentiment.

It is important for traders to understand the inter market relations and from these deduce the best way to manage, take on or reduce risk.

For Example:

Would a EURUSD Trader be more inclined or less inclined to go long with the Euro if EURGBP was falling?

Probably not enough data is available to make a fair assessment.

However if an investor noticed that the price movement was also in a downward direction in say EURAUD, EURCAD then he or she would probably think twice about placing that long trade.

The very action of falling or rising prices in different currency pairings or across different markets will give rise to negative or positive sentiment.

It is for investors to gauge through market sentiment the validity and the strengths in the market.

“Correlations” of Cross Currencies in the Forex Market

Many traders are happy to trade one currency pair or financial instrument without being concerned with the implications that are happening around them in the wider market.

Many of these traders are very skilled at following and trading one financial instrument and are able to enjoy a profitable career by being so extremely specialized and focused.

However one financial instrument does not move independently from the broader global financial market

As any seasoned market professional knows, many financial instruments move in parallel with the other.

A bullish day for USDJPY will usually lead to a bullish day for USDCHF.

In fact if one was to compare the two charts side by side it would be hard to differentiate between USDJPY and USDCHF.

This similarity in the price activity of different financial instruments is often referred to a correlation.

The definition of a correlation is the relationship between two variables that can be measured through statistical analysis.

Examples of “Correlations”

Some financial instruments such as USDJPY and USDCHF are positively correlated.

That is to say that a move in one direction for USDJPY will be confirmed by a similar move in USDCHF.

Inversely a negative correlation describes a relationship between two financial instruments which move in opposite directions.

A good example of this the US Dollar Index ($dxy) and EURUSD.

On a statistical basis if $dxy moves higher then consequently the EURUSD will move lower.

The degree of correlations however will vary.

USDJPY and USDCHF will not experience the exact same percentage moves over a given period of time and $dxy and EURUSD will not experience in percentage terms a move that is equal and opposite.

However the correlation will be derived over a set period of time and will produce a data output of between 1.00 and -1.00.

A result of 0.80 to 1.00 would be considered highly correlated and -0.80 to -1.00 to be highly negatively correlated.

Why the Price of “Cross Currencies” move similarly?

Currencies and other financial instruments are correlated because prices are ultimately moved by a multitude of factors.

This can be economic factors such as growth, employment, inflation or interest rates.

There are also political, legislative and geopolitical factors.

International trade plays an important role in driving global financial markets.

Countries which are exposed and reliant on cross border trade will have their currencies affected by the demand and supply of these resources.

For example Canada is recognized as a major producer of energy commodities and most notably Crude Oil.

Therefore there is a high degree correlation between the price of Oil and the value of USDCAD.

Understanding that correlations exist between different financial instruments is important as it allows an active trader to have an insight of the true direction the money is flowing.

As Oil is getting weaker is it that wise to be selling USDCAD at an area of resistance?

Some Famous “Correlations” of Forex Currencies

The Australian Dollar

Australia is the third largest producer of precious metals and one of the biggest producers of Gold.

Therefore it should not be a surprise that correlation between AUDUSD and Gold is usually above 0.80.

Gold is recognized as a safe haven asset

This usually means that in time of crisis due to economic or politically instability investors seek out the shelter that Gold gives.

Commodities and metals such as Gold act as a store of wealth that have the longevity to outlast these times of uncertainty.

Investing in Gold has one big drawback; although like other financial instruments Gold has the potential to appreciate in value, unlike currencies, Gold cannot be deposited at a bank for the purpose of receiving interest.

Therefore if an investor wishes to benefit from the safe haven quality of Gold and at the same benefit from an interest rate yield they could chose to purchase the Australian Dollar instead.

Japanese Yen and Canadian Dollar

Japan is one the largest global importers of Oil.

On the other hand Canada is one the largest producers and exporters of Oil.

As the price of Oil increases and decreases the fates of the Japanese and Canadian economies also changes.

Japan which is heavily reliant on Oil imports will experience a direct economic benefit from a reduction in the price of Oil.

This is because the Japanese economy is heavily reliant on export driven manufacturing economy.

Lower Oil prices will mean that Japanese manufacturers will pay less for energy.

This in turn will result in a lower cost of production and more competitive export prices.

On the other hand an increase in the price of energy commodities will benefit exporters of crude oil.

Therefore an increase in the price of Oil will act as a boost to the Canadian economy and therefore the Canadian Dollar.

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