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!

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.

First, let’s take a look at the correlation between the Dow Jones Industrial Average and the Nikkei to see how stock markets all over the globe perform relative to each other.

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.

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. A stock advisor can be of great assistance and there are helpful motley fool reviews to guide you when it comes to stock investing.