The foreign exchange (forex) market is a sizable, dynamic, and linked ecosystem where various variables affect currency movements. Trading professionals might benefit from useful information to help them make better judgments by understanding these relationships. This article explores the complex realm of currency correlations and how they relate to other financial markets, including bonds, equities, and commodities. I shall cite pertinent research and empirical evidence to clarify these correlations and their significance for forex traders.
Exchange rate correlations and the stock market
Understanding how different financial instruments interact is crucial, including the interaction between currencies and the equity market. Depending on the currency pair and the underlying circumstances, this connection may be either positive or negative.
Risk-on, Risk-off Paradigm
Investors’ risk-on, risk-off (RORO) mindset is one of the most important factors influencing the correlations between the currency and equities markets. Investors frequently seek higher returns in a riskier environment by gravitating toward riskier assets like equities and high-yielding currencies (Hossain, 2015) [1]. In contrast, during risk-off periods, investors tend to move away from stocks and into safe-haven assets like the US dollar (USD) and Japanese yen (JP Y) (Ranaldo & Söderlind, 2010) [2]. A high link between the performance of equity markets and particular currency pairs may result from this risk perception. For instance, during risk-on periods, the Australian dollar (AUD) and New Zealand dollar (NZD) frequently have a positive correlation with stocks (Cappiello et al., 2006) [3].
Industry and Regional Factors
Correlations between currencies and equity markets can also be influenced by regional and sector-specific factors. For instance, nations with significant export-oriented industries, like Germany or Japan, might see a positive correlation between their currencies and stock markets because strong export performance can result in higher corporate profits and, as a result, higher equity valuations (Chkili & Nguyen, 2014) [4].
Correlations between currencies and the commodity market
Commodity markets significantly influence currency correlations, especially in nations that depend on those markets. The most well-known examples are the so-called commodity currencies, which closely correlate with the prices of commodities like gold and oil (Kilian & Park, 2009) [5]. Examples of these currencies are the Canadian dollar (CAD), Australian dollar (AUD), and New Zealand dollar (NZD).
Currency and Oil Prices Correlations
The oil market greatly impacts the world economy, and its changes can greatly impact how closely currencies move together. For instance, when oil prices rise, nations that export oil, like Canada, Norway, and Russia, frequently see their currencies improve as higher oil revenues strengthen their economies and enhance currency demand (Amano & van Norden, 1998) [6]. Conversely, as oil prices rise, countries that import oil, such as Japan and India, may see their currencies depreciate because greater import costs harm their trade balances and economic growth (Basher et al., 2012) [7].
Currency and Gold Prices Correlations
Currency correlations can be impacted by gold, considered a safe-haven asset and particularly effective when the economy or markets are turbulent. As a result of investors’ preference for safe-haven assets, the Swiss franc (CHF) and gold prices, for instance, have historically shown a positive correlation (Baur & Lucey, 2010) [8]. Similarly, to this, the Australian dollar (AUD) and gold prices frequently have a positive correlation because Australia is a significant producer and exporter of gold (Chen et al., 2012) [9].
Correlations between currencies and the bond market
Another important component of the financial market puzzle is the bond market, where interest rate differences and monetary policy decisions greatly impact currency correlations. For example, a currency that has higher rates backing it in the bond market will typically perform better than one that doesn’t.
Differences in Interest Rates
Currency correlations can be significantly impacted by international interest rate differences. Foreign investment is typically attracted to countries with higher interest rates as investors look for greater returns on their cash. According to Engel (2014) [10], this greater demand for the nation’s currency with higher interest rates can cause it to appreciate relative to other currencies. For instance, the US dollar (USD) typically gains strength versus other currencies when the US Federal Reserve raises interest rates because higher interest rates make USD-denominated assets more desirable to investors (Clarida et al., 2003) [11].
Monetary Policy Actions
Central banks’ monetary policy actions, such as quantitative easing (QE) or forward guidance, can also influence currency correlations. These actions can affect interest rates, inflation expectations, and investors’ risk appetite, which can all have knock-on effects on currency correlations (Neely, 2015) [12]. For instance, during the European Central Bank’s (ECB) quantitative easing program, the euro (EUR) weakened against other currencies, as the expansionary monetary policy led to lower interest rates and increased the supply of euros in the market (Fratzscher et al., 2013) [13].
Conclusion
Forex traders must comprehend currency correlations and how they relate to other financial markets because they can boost trading techniques and offer insightful information. Risk aversion, regional and industry-specific characteristics, commodity prices, and monetary policy moves are just a few of the variables that influence the complex web of relationships between currencies, equities, commodities, and bonds. Traders can enhance their decision-making and more effectively manage the complexities of the forex market by remaining knowledgeable about these relationships and keeping an eye on the developments in the international financial markets.
References:
[1] Hossain, M. S. (2015). Risk-on/risk-off and carry trades: a reappraisal. International Journal of Finance & Economics, 20(1), 68-83.
[2] Ranaldo, A., & Söderlind, P. (2010). Safe haven currencies. Review of Finance, 14(3), 385-407.
[3] Cappiello, L., Engle, R. F., & Sheppard, K. (2006). Asymmetric dynamics in the correlations of global equity and bond returns. Journal of Financial Econometrics, 4(4), 537-572.
[4] Chkili, W., & Nguyen, D. K. (2014). Exchange rate movements and stock market returns in a regime-switching environment: Evidence for BRICS countries. Research in International Business and Finance, 31, 46-56.
[5] Kilian, L., & Park, C. (2009). The impact of oil price shocks on the U.S. stock market. International Economic Review, 50(4), 1267-1287.
[6] Amano, R. A., & van Norden, S. (1998). Oil prices and the rise and fall of the US real exchange rate. Journal of International Money and Finance, 17(2), 299-316.
[7] Basher, S. A., Haug, A. A., & Sadorsky, P. (2012). Oil prices, exchange rates, and emerging stock markets. Energy Economics, 34(1), 227-240.
[8] Baur, D. G., & Lucey, B. M. (2010). Is gold a hedge or a safe haven? An analysis of stocks, bonds and gold. Financial Review, 45(2), 217-229.
[9] Chen, Y. C., Chiang, T. C., & So, M. K. (2012). Asymmetric return and volatility transmission in production-based commodity currencies. International Review of Economics & Finance, 24, 97-108.
[10] Engel, C. (2014). Exchange rates and interest parity. Handbook of International Economics, 4, 453-522.
[11] Clarida, R., Sarno, L., Taylor, M. P., & Valente, G. (2003). The out-of-sample success of term structure models as exchange rate predictors: a step beyond. Journal of International Economics, 60(1), 61-83.
[12] Neely, C. J. (2015). Unconventional monetary policy had large international effects. Journal of Banking & Finance, 52, 101-111.
[13] Fratzscher, M., Lo Duca, M., & Straub, R. (2013). On the international spillovers of US quantitative easing. ECB Working Paper Series, No. 1557.