Equities are like crystal balls – they can help you predict the future of currencies.
Forex and Global Equity Markets
Did you know that equity markets can also be used to help gauge currency movement?
In a way, you can use the equity indices as some kind of a forex crystal ball. Based on what you see on the television, what you hear on the radio, and what you read in the newspaper, it seems that the stock (equity) market is the most closely covered financial market.
One thing to remember is that in order to purchase stocks from a particular country, you must first have the local currency. To invest in stocks in the Japan, a European investor must first exchange his euros (EUR) into Japanese yen (JPY).
This increased demand for JPY causes the value of the JPY to appreciate. On the other hand, selling euros increases its supply, which drives the euro’s value lower.
When the outlook for a certain stock market is looking good, international money flows in.
On the other hand, when the stock market is struggling, international investors take their money out and look for a better place to park their funds.
Even though you may not trade stocks, as a forex trader, you should still pay attention to the stock markets in major countries.
If the stock market in one country starts performing better than the stock market in another country, you should be aware that money will probably be moving from the country with the weaker stock market to the country with the stronger stock market.
This could lead to a rise in value of the currency for the country with the stronger stock market, while the value of the currency could depreciate for the country with the weaker stock market.
Here’s the general idea:
Strong stock market = strong currency.
Weak stock market = weak currency. If you bought the currency from the country with the stronger stock market and sold the currency from the country with the weaker stock market, you can potentially make some nice dough.
Not too familiar with the major global equity indices? It’s your lucky day! Here they are!
|Dow||The Dow Jones Industrial Average (or Dow for short), is considered to be one of the premier stock indexes in the U.S. It measures how well the top 30 publicly owned companies are trading. Despite the name, barely any of the companies have anything to do with industrial production and are instead representative of some of the biggest companies in America. It is closely watched by investors around the world and is highly indicative of market sentiment, thus making it sensitive to both local and foreign economic and political events. The companies that are part of the Dow are so large that you probably deal with at least one of them every day. Imagine life without AT&T, McDonalds, Pfizer or Intel? Yes – these companies are all listed in the Dow!|
|S&P500||The Standard & Poor 500, more commonly known as the S&P 500, is a weighted index of the stock prices of the 500 largest American companies. It is considered a bellwether for the American economy and is used to predict its direction. After the Dow Jones Industrial Average, it is the most traded index in the U.S. Some mutual funds, exchange-traded funds, and other funds such as pension funds, are designed to track the performance of the S&P 500 index. Hundreds of billions of U.S. dollars have been invested in this fashion.|
|NASDAQ||NASDAQ stands for National Association of Securities Dealers Automated Quotations. It refers to the largest electronic screen-based equity securities trading market in the U.S., comprising of approximately 3,700 companies and corporations. It also boasts of having the largest trading volume among the world’s stock markets.|
|Nikkei||The Nikkei, similar to the Dow Jones Industrial Average, is the most widely quoted average of the Japanese stock market. It is a price-weighted average of the top 225 companies and is supposed to be reflective of the overall market.The Nikkei includes companies like Toyota, Japan Airlines, and Fuji film.|
|Dax||The DAX is short for the Deutscher Aktien Index (you’re probably better off remembering just DAX). It is the stock market index in Germany that consists of the top 30 blue chip companies that are traded on the Frankfurt Stock Exchange. With Germany being the largest economy in the euro zone, the DAX is normally the most closely watched index within the whole euro zone. Some companies that are part of the DAX are Adidas, BMW, and Deutsche Bank.|
|DJ EURO STOXX 50||The Dow Jones Euro Stoxx 50 index is the euro zone’s leading blue-chip index. It comprises over 50 top-sector stocks from 12 euro zone countries. It was created by Stoxx Ltd., which is a joint venture of Deutsche Boerse AG, Dow Jones & Company and SIX Swiss Exchange.|
|FTSE||The FTSE (pronounced “footsie”) index tracks the performance of the most highly capitalized UK companies listed on the London Stock Exchange. There are several versions of this index, such as the FTSE 100 or FTSE 250, depending on the number of companies included in the index.|
|Hang Seng||The Hang Seng index is a stock market index in Hong Kong. By recording and monitoring the daily price changes of the stocks included in the index, it tracks the overall performance of the Hong Kong stock market. This index is currently compiled by the HSI Services Limited, which is a subsidiary of Hang Seng Bank.|
The Relationship Between Stocks and Forex
One issue with using global equity markets to make forex trading decisions is figuring out which leads which.
It’s like answering that age old question, “Which came first, the chicken or the egg?” or “Who’s yo daddy?!”
Are the equity markets calling the shots? Or is it the forex market that wears the pants in the relationship? The basic theory is that, when a domestic equity market rises, confidence in that specific country grows as well, leading to an inflow of funds from foreign investors.
This tends to create a demand for the domestic currency, causing it to rally versus other foreign currencies.
On the flip side, when a domestic equity market performs terribly, confidence falters, causing investors to convert their invested funds back into their own local currencies.
Sounds great in theory, but in reality, it’s…complicated. For example, the historical relationship between the U.S. dollar and the S&P 500 hasn’t been consistent.
As shown below, over the last 20 years they have moved together, moved in opposite directions, and have been unrelated.
But that doesn’t mean the relationship is useless. You just have to know when the correlation is working (whether negative or positive) and when it’s not.
Here’s an example where for U.S. and Japan stocks moved in opposite directions of their currencies.
Any upbeat economic figures in the U.S. and Japan more often than not weigh down on their respective currencies, the dollar and yen.
Since the turn of the century, the Dow Jones Industrial Average and the Nikkei 225, the Japanese stock index, have been moving together like lovers on Valentine’s Day, falling and rising at the same time. Also notice that sometimes one index leads, rallying or dropping first before being followed by the other index.
It doesn’t happen every single time, but you could say that stock markets in the world generally move in the same direction.
How the Stock Market Affects the Forex Market
Nikkei and USD/JPY
Before the global economic recession that started in 2007, when most economies suffered consecutive quarters of negative GDP growth, the Nikkei and the USD/JPY were inversely correlated.
Investors believed that the performance of the Japanese stock market reflected the status of the country, so a rally in the Nikkei led to a strengthening of the yen. The opposite also held true. Whenever the Nikkei would drop, USD/JPY would rise as well.
When the financial crisis hit, however, the relationships just went crazy like Lindsay Lohan.
The Nikkei and USD/JPY, which used to move oppositely, now move in the same direction.
Amazing isn’t it?
Who would’ve thought that stocks would have something to do with the foreign exchange market?
Correlation Between USD/JPY and Dow
Let’s take a look at the correlation between the USD/JPY and the Dow. Based on what you read earlier, you might assume that the USD/JPY and Dow would be highly correlated.
However, a look at the chart below would tell you that it isn’t quite the case. While the correlation is positive, it isn’t as strong.
Take a look at the Dow (blue line).
It peaked at 14,000 late in 2007 before dropping like a hot potato in 2008. At the same time, USD/JPY (orange line) also fell, but not as sharply as the Dow.
This serves as a reminder that we should always take into account fundamentals, technicals, and market sentiment, so always read up!
Don’t take correlations for granted because they aren’t a sure fire thing!
How to Use EUR/JPY as a Leading Indicator for Stocks
As we said earlier, in order for someone to invest in a particular stock market, one would need the local currency in order to purchase stocks.
You can imagine what the effect of stock markets like the DAX (that’s the German stock market), have on currencies. In theory, whenever the DAX rises, we can probably expect the euro to rise as well, as investors need to get a hand on some euros.
While the correlation is imperfect, statistics show that it still holds pretty accurately.
We here at BabyPips.com did a little research of our own and found out that EUR/JPY seems to be highly correlated with stock markets across the globe.
You should know that the yen, along with the U.S. dollar, are considered to be safe havens amongst the major currencies. Whenever confidence in the global economy is down and traders are fearful, we typically see traders take their money out of the stock markets, which leads to a drop in the values of the DAX and S&P500.
With money flowing out of these markets, we usually see EUR/JPY fall as traders run for cover.
On the flip side, when the sun is bright and risk appetite is rampant, investors pour their money into stock markets, which in turns leads to a rise in the EUR/JPY.
Take a look at charts below to see the correlation between the EUR/JPY and the DAX and S&P500.
The correlation seems to have held well this past decade, as EUR/JPY and both indexes rose steadily together, until 2008, when we were hit with the Grear Financial Crisis (GFC).
In late 2007, EUR/JPY had hit its peak, and so did the stock indexes.
Intermarket Analysis Cheat Sheet
That’s a lot of intermarket correlations to remember so let’s do a quick recap.
The price action of currencies is often driven by their relationship with commodities, bonds, and stock indices.
|Gold||USD||During times of economic unrest, investors tend to dump the dollar in favor of gold. Unlike other assets, gold maintains its intrinsic value.|
|Gold||AUD/USD||Australia is the third biggest gold producer in the world, sailing out about $5 billion worth a year.|
|Gold||NZD/USD||New Zealand (rank 25) is also a large producer of gold.|
|Gold||USD/CHF||Over 25% of Switzerland’s reserves are backed by gold. As gold prices go up, the pair moves down (CHF is bought).|
|Gold||USD/CAD||Canada is the 5th largest producer of gold in the world. As gold price goes up, the pair tends to move down (CAD is bought).|
|Oil||USD/CAD||Canada is one of the top oil producers in the world. It exports around 2 million barrels of oil a day to the U.S. As oil prices go up, the pair moves down.|
|Gold||EUR/USD||Since both gold and euro are considered “anti-dollars,” if the price of gold goes up, EUR/USD may go up as well.|
|Bond yields||Local Currency||An economy that offers higher returns on its bonds attract more investments. This makes its local currency more attractive than that of another economy offering lower returns on its bonds.|
|Dow||Nikkei||The performance of the U.S. economy is closely tied with Japan.|
|Nikkei||USD/JPY||Investors consider the yen as a safe-haven and tend to seek it during periods of economic distress.|