How stocks affect forex markets

The world of finance is an interconnected web made up of many kinds of market participants. Political events, central bank policies and environmental happenings can all affect how markets trade and traders need to be alert to all of the above in order to trade successfully.

However, as big as forex, commodity and bond markets are, and as much as they are connected to one another, it could be said that stock markets alone are the underlying driving force in the financial markets.

The reason for this is that stocks are the companies that drive our capitalist economy and it is they that are ultimately responsible for the things we buy and the way we live our lives. Because of this fact, stocks tend to be the leading indicators in markets.

By that, I mean stocks often move first before anything else. They often decline well in advance of recessions, they react first to important news outbreaks and they often indicate the best course of action for other traders to take.

When stocks are cheap

Stocks become cheap, generally, towards the end of a recession and after a decent bear market has taken place. During this time, corporate earnings have dropped substantially, economic growth has stalled and stock prices have shown signs of bottoming out.

It is at this point that forex traders should be most optimistic and look to buy some of the currencies that will benefit most from an upturn in the economy. High growth currencies from emerging markets such as the Brazilian Real or the Turkish Lira, are likely to do well during the beginning phases of a new bull market in stocks. As are those currencies that have dropped the most during the preceding bear market, the British pound, or the euro perhaps.

It's for this reason that earnings season can be just as important a time for forex traders as equity traders.

When stocks are expensive

When stocks are expensive, it's likely that the bull market is in its final stage. Utility stocks and blue chips tend to be the only stocks making new highs and small cap stocks are starting to slide.

Whenever stocks are either expensive or due for a correction, forex traders should act to avoid those currencies that have moved up in tandem with stocks.

Higher growth currencies such as the Brazilian Real or Turkish Lira should be exchanged for the safety of lower yielding currencies like the Japanese yen, the US dollar or the Swiss franc. These three currencies are the main safe havens for currency traders and should be sought out whenever there are signs of stress.