One of the first things that new traders to the FX markets learn is that many currencies are correlated with other markets. For instance, the close relationship between oil and the Canadian dollar or certain metals and the Australian dollar are intuitive given the importance of exporting those commodities for the Canadian and Australian economies.
One strong, but less obvious, correlation is the tight connection between AUD/JPY and global stock markets. In this case, the factor linking the two seemingly-disparate markets is investors’ risk appetite. When market participants are feeling optimistic about global economic growth, they tend to buy stocks at the expense of more conservative investments such as bonds.
A similar dynamic takes place in the FX market, where upbeat traders will buy higher-yielding currencies with underlying economies leveraged to global economic growth (e.g. the Australian and New Zealand dollars) and sell lower-yielding currencies with relatively stable economies (e.g. the Japanese yen and Swiss franc). Conversely, when traders are apprehensive about the potential for global economic growth, they tend to unwind those trades by selling the higher-yielding currencies and buying perceived safe havens. This is the essence of the so-called “carry trade,” a major short- and long-term driver of FX movements.
This strong correlation offers traders several actionable insights. Most straightforwardly, if a trader feels strongly that the broad stock market is due to fall or rise, he/she could use AUD/JPY to express that view in a highly liquid, 24-hour market that offers the potential for leverage. Alternatively, traders can watch for divergences between the S&P 500 and AUD/JPY as a sign that one (or both) of the markets is vulnerable to a reversal.
We saw that exact scenario in Q3 2018, when the S&P 500 rallied to new highs, while AUD/JPY continued to languish. The divergence indicated that stock traders should be more skeptical toward the rally in the S&P 500, and sure enough, the index came unwound months’ worth of a gains in a couple of weeks in October. Such divergences can emerge over longer time horizons given the upward tendency of stock investments, they can still provide valuable signals to short-term and swing traders.
This research is for informational purposes and should not be construed as personal advice. Trading any financial market involves risk. Trading on leverage involves risk of losses greater than deposits.
Editors’ Picks
EUR/USD regains traction, recovers above 1.0700
EUR/USD regained its traction and turned positive on the day above 1.0700 in the American session. The US Dollar struggles to preserve its strength after the data from the US showed that the economy grew at a softer pace than expected in Q1.
GBP/USD returns to 1.2500 area in volatile session
GBP/USD reversed its direction and recovered to 1.2500 after falling to the 1.2450 area earlier in the day. Although markets remain risk-averse, the US Dollar struggles to find demand following the disappointing GDP data.
Gold holds around $2,330 after dismal US data
Gold fell below $2,320 in the early American session as US yields shot higher after the data showed a significant increase in the US GDP price deflator in Q1. With safe-haven flows dominating the markets, however, XAU/USD reversed its direction and rose above $2,340.
XRP extends its decline, crypto experts comment on Ripple stablecoin and benefits for XRP Ledger
Ripple extends decline to $0.52 on Thursday, wipes out weekly gains. Crypto expert asks Ripple CTO how the stablecoin will benefit the XRP Ledger and native token XRP.
After the US close, it’s the Tokyo CPI
After the US close, it’s the Tokyo CPI, a reliable indicator of the national number and then the BoJ policy announcement. Tokyo CPI ex food and energy in Japan was a rise to 2.90% in March from 2.50%.
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