Forex and Stock Correlations

In the age of instantaneous communication, market correlation is more significant now than it ever has been before. In days gone by, often markets stood "alone", or at least the correlations between them were lagging so much that it did not appear that they were very related or interconnected. But no more.

As news zips around the globe, data from China affects the Pacific, European and American markets almost at once. So the question arises, what are the correlations between various markets, and, can we trade them?

If we examine the traditional correlations between stock and currency markets, we should note that the drivers which move them are not the same. Let's start with stocks. They are broadly driven by two factors: interest rates and earnings. Once upon a time, interest rates below 8% were said to propel stocks higher. And once rates fell to that level or lower, traders should begin buying in. With interest so low, every company would be making a profit (of course that dynamic has grossly changed). But nevertheless, low rates generally make for rising stocks. On the other hand, rising rates make for falling stocks. This is the dilemma where US and other policy makers now find themselves. They know rates cannot stay at these absurdly low levels forever. But how can you raise them when they are not stimulating the economy. Such an action would crush anything that's left of the economy.

But when rates do begin to increase, and stocks are falling, as a rule, bonds are going up. As they draw more interest from investors for their higher return, we see they usually move in tandem, or an opposite correlation from stocks or equities.

Currencies act a little more like bonds than they do stocks. If interest rates are falling, the interest by traders in that currency will fall also. Why? Because of a lesser return. As the US is presently setting its rates at .25%, why would I as a currency investor want to buy the USD over the Aussie $ which is paying 4.5%? As a rule, I wouldn't. But we are in the midst of an inverse market relationship. Now the lower paying currency is strengthening because of fear in the market. Fear drives investors to what they perceive as safety and liquidity. Right now, that is the USD.

So the important thing to remember now is that correlations also change. At times, strength in the USD is mirrored in strength in the equities. But during this fearful time, falling US equities have meant a strengthening dollar. On days when counter parties to the dollar were having good equity days, that was good for their currency.

Thus there are correlations, but they appear to be rather short lived for our style of trading. Even as I write this the bottom is dropping out of the S&P which would normally be good for the dollar against the euro and sterling. But the pound is up 250 pips and the euro 150. That is a huge disconnect for what has been happening lately.

So be careful when you hear (especially talking heads on Bloomberg and CNBC or Fox) talking about these correlations or negative correlations. They are not as reliable or as simple as some would lead you to believe. They are interconnected, but apart from long secular trends, they are more like minefields than good trading strategies.

Happy Trading,
Bill
www.thefxtradingmasters.com
bill@thefxtradingmasters.com