{"id":89750,"date":"2016-05-22T18:23:59","date_gmt":"2016-05-22T22:23:59","guid":{"rendered":"http:\/\/countingpips.com\/?p=89750"},"modified":"2016-05-15T18:24:18","modified_gmt":"2016-05-15T22:24:18","slug":"how-forex-connects-to-other-markets","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/forex\/2016\/05\/how-forex-connects-to-other-markets\/","title":{"rendered":"How Forex connects to other markets"},"content":{"rendered":"
May 22, 2016<\/div>
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By Admiral Markets<\/b><\/p>\n

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Dear Traders,<\/p>\n

If you want to successfully trade the markets, knowing just one side of the coin is not enough.<\/p>\n

There is a strong correlation between Forex and other markets (e.g equities and commodities).<\/p>\n

You need to understand the intermarket connection, to make better trades.<\/p>\n

This is where I can help you.<\/p>

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I will teach you the basics of intermarket correlations, so you can learn to trade like a pro.<\/em><\/p>\n

Knowing about Forex intermarket correlation will:<\/p>\n

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  1. improve your knowledge about price action flow<\/li>\n
  2. give you an edge in your Forex trading<\/li>\n
  3. make you more confident in your trades; and<\/li>\n
  4. teach you which pairs to trade during major sessions.<\/li>\n<\/ol>\n

    Forex market and bonds<\/h2>\n

    The global bond market is the second largest financial market in the world, right behind the leading Forex market.<\/p>\n

    Government bonds make up the largest percentage of the global bond market.<\/p>\n

    Investors consider these bonds risk-free investments, because strong national governments back them.<\/p>\n

    It is important to mention that investors who wish to buy government bonds, must buy these bonds with the currency of the represented government.<\/p>\n

    So let’s assume that international investors wish to buy US government bonds.<\/p>\n

    To do this, they must first exchange their local currencies for US dollars (USD).<\/p>\n

    Basic economics implies that the increased demand for USD:<\/p>\n

    …drives the value of USD higher while simultaneously…<\/p>\n

    …the increased supply of international currencies on the market, drives the value of these currencies lower.<\/p>\n

    Additionally, bond yield differentials usually move in tandem with currency pairs.<\/p>\n

    You might be wondering why?<\/p>\n

    It happens because higher yielding currencies attract capital flows.<\/p>\n

    Vice versa, the cost of owning the lower yielding currency increases as the bond yield differential moves in favor of the sold currency.<\/p>\n

    For example, the cost of owning the Japanese yen (JPY) and selling USD, will increase as US bond yields increase relative to Japanese bond yields.<\/p>\n

    <\/p>\n

    Forex market and equities<\/h2>\n

    Have you ever wondered why we traders prefer the term equities<\/em> to indices<\/em>?<\/p>\n

    It’s because the underlying asset in the index, is the price of a basket of publicly listed company shares.<\/p>\n

    In short, equities are merely a stock or any other security representing an ownership interest in the company (regardless of whether the company is public or private).<\/p>\n

    You need to remember that:<\/p>\n

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    1. the Forex market is strongly related to equities; and<\/li>\n
    2. equities and Forex can correlate in a number of different ways.<\/li>\n<\/ol>\n

      Economies with a strong manufacturing plus exporting sector (e.g. Japan and Germany), can experience a currency’s strength and\/or weakness.<\/p>\n

      When JPY or euro (EUR) weakens substantially, it makes their products cheaper in the local currency of their trading partners.<\/p>\n

      This leads to higher exports and corporate profits for these exporting nations.<\/p>\n

      In turn:<\/p>\n

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      1. this raises company share prices; and<\/li>\n
      2. theoretically causes the indices to go higher in these exporting nations.<\/li>\n<\/ol>\n

        Meanwhile Yen (which is seen as a global reserve currency), is often linked to risk-on and risk-off sentiments associated with risky markets (e.g. equities plus property).<\/p>\n

        When there is a prevailing risk-off sentiment in risky markets, they usually sell risky assets.<\/p>\n

        The proceeds go into safer investments such as bonds or sometimes gold.<\/p>\n

        Due to low borrowing costs in Japan, many Japanese investors borrow and invest their proceeds in foreign risky markets for a differential gain.<\/p>\n

        When a risk-off sentiment prevails, it usually leads to these same investors selling risky assets (e.g. stock markets go down).<\/p>\n

        This creates more demand for JPY as the funds return home.<\/p>\n

        Additionally:<\/p>\n

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        1. Japan has a deep bond market; so<\/li>\n
        2. demand for Japanese bonds usually creates further demand for JPY.<\/li>\n<\/ol>\n

          In this chapter, I will focus on AUD, USD, JPY correlations because equities have a strong correlation with both AUD\/JPY and USD\/JPY.<\/p>\n

          Traders should really benefit from this knowledge.<\/p>\n

          Basically, when it’s a risk-on environment:<\/p>\n

          …commodities prices tend to increase\u2026<\/p>\n

          …and traders go long AUD due to that factor.<\/p>\n

          When commodities prices go up, stock markets go up and there is demand for positive swaps on AUD pairs (as opposed to JPY).<\/p>\n

          In a risk-off environment, usually the opposite occurs.<\/p>\n

          As a result, JPY appreciates due to repatriation of foreign flows from Japan back to their local currency.<\/p>\n

          There is a strong connection between AUD\/JPY and equities markets.<\/p>\n

          You should always observe the correlation, particularly with China’s stock market.<\/p>\n

          When China’s stock market is plummeting:<\/p>\n

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          1. investors fear that it will slow global economic activity, which<\/li>\n
          2. causes a risk-off sentiment; and<\/li>\n
          3. Forces equities (China A50 Cash) to go down.<\/li>\n<\/ol>\n

            As we know, China’s stock market opened up for margin lending earlier in 2015 and made substantial gains over a short time period.<\/p>\n

            Once investors realised that the company share price valuations were far too expensive, the selling triggered margin calls as the index made its way down.<\/p>\n

            Equity brokers in China were taking all kinds of assets (including commodities contracts) as collateral, which led to further price rout in commodities prices.<\/p>\n

            Pro tip:<\/p>\n

            …Friday is notorious in equities for the lack of buyers, because investors generally don’t like taking risks over a weekend…<\/p>\n

            …so you may find that equities can reverse and head lower on Fridays.<\/p>\n

            <\/p>\n

            Forex market and Commodities<\/h2>\n

            There is a close relationship between commodity values and major commodity exporters, including the:<\/p>\n

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            1. Australian dollar (AUD)<\/li>\n
            2. New Zealand dollar (NZD)<\/li>\n
            3. Canadian dollar (CAD).<\/li>\n<\/ol>\n

              If the price of commodities rises, the value of these currencies will also rise.<\/p>\n

              Vice versa, if the price of commodities falls – the value of these currencies will typically fall too.<\/p>\n

              Different commodities have a different effect on various Forex pairs.<\/p>\n

              For example, AUD has a strong correlation with:<\/p>\n

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              1. gold<\/li>\n
              2. iron ore<\/li>\n
              3. coal<\/li>\n
              4. copper; and<\/li>\n
              5. liquefied natural gas (LNG).<\/li>\n<\/ol>\n

                As the price of these commodities goes higher, the value of AUD usually goes higher.<\/p>\n

                Paying attention to what is happening in the commodity market during trading, can also give you the edge you have been looking for.<\/p>\n

                Check out this video for more information on that subject.<\/p>\n