By Admiral Markets

Dear Traders,

If you want to successfully trade the markets, knowing just one side of the coin is not enough.

There is a strong correlation between Forex and other markets (e.g equities and commodities).

You need to understand the intermarket connection, to make better trades.

This is where I can help you.

I will teach you the basics of intermarket correlations, so you can learn to trade like a pro.

Knowing about Forex intermarket correlation will:

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

Forex market and bonds

The global bond market is the second largest financial market in the world, right behind the leading Forex market.

Government bonds make up the largest percentage of the global bond market.

Investors consider these bonds risk-free investments, because strong national governments back them.

It is important to mention that investors who wish to buy government bonds, must buy these bonds with the currency of the represented government.

So let’s assume that international investors wish to buy US government bonds.

To do this, they must first exchange their local currencies for US dollars (USD).

Basic economics implies that the increased demand for USD:

…drives the value of USD higher while simultaneously…

…the increased supply of international currencies on the market, drives the value of these currencies lower.

Additionally, bond yield differentials usually move in tandem with currency pairs.

You might be wondering why?

It happens because higher yielding currencies attract capital flows.

Vice versa, the cost of owning the lower yielding currency increases as the bond yield differential moves in favor of the sold currency.

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.

Forex market and equities

Have you ever wondered why we traders prefer the term equities to indices?

It’s because the underlying asset in the index, is the price of a basket of publicly listed company shares.

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).

You need to remember that:

1. the Forex market is strongly related to equities; and
2. equities and Forex can correlate in a number of different ways.

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

When JPY or euro (EUR) weakens substantially, it makes their products cheaper in the local currency of their trading partners.

This leads to higher exports and corporate profits for these exporting nations.

In turn:

1. this raises company share prices; and
2. theoretically causes the indices to go higher in these exporting nations.

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).

When there is a prevailing risk-off sentiment in risky markets, they usually sell risky assets.

The proceeds go into safer investments such as bonds or sometimes gold.

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

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

This creates more demand for JPY as the funds return home.

Additionally:

1. Japan has a deep bond market; so
2. demand for Japanese bonds usually creates further demand for JPY.

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

Traders should really benefit from this knowledge.

Basically, when it’s a risk-on environment:

…commodities prices tend to increase…

…and traders go long AUD due to that factor.

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

In a risk-off environment, usually the opposite occurs.

As a result, JPY appreciates due to repatriation of foreign flows from Japan back to their local currency.

There is a strong connection between AUD/JPY and equities markets.

You should always observe the correlation, particularly with China’s stock market.

When China’s stock market is plummeting:

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

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

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.

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

Pro tip:

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

…so you may find that equities can reverse and head lower on Fridays.

Forex market and Commodities

There is a close relationship between commodity values and major commodity exporters, including the:

1. Australian dollar (AUD)
2. New Zealand dollar (NZD)
3. Canadian dollar (CAD).

If the price of commodities rises, the value of these currencies will also rise.

Vice versa, if the price of commodities falls – the value of these currencies will typically fall too.

Different commodities have a different effect on various Forex pairs.

For example, AUD has a strong correlation with:

1. gold
2. iron ore
3. coal
4. copper; and
5. liquefied natural gas (LNG).

As the price of these commodities goes higher, the value of AUD usually goes higher.

Paying attention to what is happening in the commodity market during trading, can also give you the edge you have been looking for.

Check out this video for more information on that subject.

The good news is that you can have the correlation table on your MT4 platform.

Long gone are the days when you needed to search across various websites.

Correlation tables will always provide you with intermarket connection for any time frame in MetaTrader 4 Supreme Edition.

The tools that Admiral Markets provides you with, are essential in your Forex trading journey – so use them to your advantage.

I hope this article helped you better understand the price action flow within different markets.

With that said and given the bonds/equities market data, what it is your opinion on AUD/JPY?

Have you tried trading it using correlation with equities?

Post your thoughts and ideas in the comments below.

Cheers and safe trading,

Nenad
Article by Admiral Markets

Source: How Forex connects to other markets

Admiral Markets is a leading online provider, offering trading with Forex and CFDs on stocks, indices, precious metals and energy.