An interesting phenomenon in the financial markets is correlation. When understood correctly, taking advantage of market correlations are an effective way to manage risk. But what are market correlations – and why do they matter to Forex traders? Let’s explore the concept in detail.
If you’re unfamiliar with market correlation, this is simply a way of measuring a link between two financial markets
As a currency trader, I constantly look for correlations between other financial markets (such as stock indexes and commodities) and currencies. Why? It’s simple – these links effectively indicate price direction, which is useful when it comes to making trading decisions.
What are financial markets?
If you’re new to Forex trading, you might be unfamiliar with the term ‘financial markets’. Traders use this terms to describe a category of tradable financial assets.
One market you’ll be familiar with as a Forex trader is currencies.
To trade currencies, you’ll use a broker which allows you to place a trade via a trading platform, such as MetaTrader 4. It’s likely that your broker will also allow you to trade within other financial markets – including stocks, precious metals and other commodities.
Some financial markets are correlated. This means that there is a link between their prices.
Commodity and Forex markets
What you need to know as Forex trader is that correlations are either positive or negative. The strength of correlations are also fluid – meaning they can change over time.
Firstly, let’s take a look at positive market correlations. This is where the two financial markets move in the same direction.
Commodities and Forex are an excellent example of two markets that are positively correlated. The reasons this happens is simple. Several major nations are reliant on strong commodities markets in order to sustain their overall economic growth.
Let’s take a look at some examples. Canada is a prominent exporter of oil. Australia is a significant producer of minerals, while New Zealand relies heavily on agriculture exports. These economies are dependent on the demand for commodities. Therefore, it makes sense that their currencies have a positive correlation with the price of their respective commodities.
For instance, if oil prices suddenly slump, then Canada will make less money. As a result, Canada’s GDP output will fall. If this starts to affect other areas – such as inflation or employment – the market might start to worry about its long-term implications.
This type of shift can cause the central bank to react by adjusting interest rates, one way or another. It’s why speculative traders are always watching commodity prices, before trading the currency of the most reliant nation alongside it.
Other correlations exist too. For example, there can be correlations between stock or bond markets and particular currencies in the Forex market.
However, there’s a key difference here which is important to understand. These markets typically don’t react to each other. Instead, they react in a predictable manner to external risk events.
For example, an increase in interest rates usually does two things. Firstly, the respective country’s currency increases in value. Secondly, the respective country’s stock market will decrease in value (native currencies and stock markets tend to have a negative correlation). As you can see, each of these markets reacts in a predictable manner to a monetary policy change.
This is unlike the previous example of commodity and Forex markets. In these instances, the move in currency price is a direct reaction to the move in commodity prices.
Correlations are fluid
As a trader, you need to remember that there is no such thing as a fixed correlation. Economic circumstances can change over time, affecting existing correlations.
Let’s look at Canada again to explore this in detail.
Canada has traditionally been heavily reliant on Oil. This means that the Canadian dollar tends to move in line with Oil prices. That’s why Forex traders place heavy focus on watching Oil prices.
However, this correlation is not set in stone. If Canada re-orientated its economy to renewable energy and reduced its oil exports, then its currency would cease to move so closely with oil prices.
The same principle applies to the indirect links we looked at earlier. Just because the stock markets and currency markets react in a fairly stable manner to something like interest rate adjustments at this moment in time, there is nothing stopping this changing as economic events unfold.
It pays to not blindly follow economic ‘rules’ in this way.
Instead, always be tuned into the fundamentals and understand exactly why any correlations exist. By doing so, you will be aware if the underlying reasons for them ever change.
This will be much more helpful to you when you are trying to make money.
I hope you have found this article useful. If you have any questions, please leave them in the comments below. I’ll try my best to reply to as many as I can.