Spotlight on Forex

Tracking Correlations Between Equities, Commodities, and Currencies

stevemisic200.jpg
Steve Misic
Online Trading Academy, E-mini Futures, Forex, Equities, Options, Commodity Futures, Personal Trading Plan and Platform Immersion Instructor

In the Forex markets, prices move for many reasons. When US companies build factories overseas, the payroll of those workers must be paid in local currency which means the US Dollar is exchanged for units of the local currency. When the goods that are manufactured in this factory are sold in foreign countries, the conversion of those currencies back into US Dollars eventually takes place. US companies that extend credit to overseas customers often need to hedge against the risk that the currencies of their customers depreciates to the point of wiping out the expected profit on the sale of the goods before payment is received. These are a few of the basic business reasons for day-to-day movements in the Forex markets.

Since 2001, the volume of trading in the Forex market has more than doubled as many companies decided to become speculators as well as hedgers in the Forex markets. When other market participants that also speculate, such as hedge funds and money management firms are considered, between 70% to 90% of the recent movements in the Forex markets are due to speculation, accounting for the explosion in the amounts of daily Forex trading. Speculators desire to profit from the movement of an asset without the intent of taking delivery of the asset. They provide necessary liquidity to the party that is attempting to hedge some form of risk. Hedge funds and money management firms also speculate in other markets such as equity and commodities markets. Since the amount of money available to speculate is finite, money tends to flow into and out of various asset classes. Tracking the movement of the so-called hot money into and out of each asset class is possible if a trader understands the reasons for the sudden shifts. Once the reasons are clear, a chart can be constructed to give the Forex trader a heads-up on which currencies are strengthening for potential long trades, and which pairs are weakening for potential shorting opportunities. If the trader also trades equities or commodities, this information can be used to time trading decisions in those markets, as well.

In the currency markets, money flows into countries to take advantage of higher interest rates to earn higher returns. This strengthens one currency in the pair and weakens the other currency. If the US Dollar is one of the currencies in the pair, then assets that move inversely to the US Dollar will begin to strengthen as the US Dollar weakens. Assets that are priced in dollars such as gold, oil, and copper will move inversely to the US Dollar. Producers of these goods need to charge higher prices to compensate for the weak dollar. The US Dollar and the US Equities markets have been negatively correlated especially since the credit crisis and start of the recent recession. One reason for this is that exports to growing economies such as China are positives for the US economy during this period of the US consumer deleveraging. For exports to continue, the US dollar needs to remain weak. Stocks of companies that are exporting products tend to rise when the US Dollar weakens. Companies involved in the exports of certain commodities also benefit from the weak dollar. Another term to become familiar with is "risk aversion." Risky assets such as equities and commodities have been moving up on days when the US Dollar is weak. When fear is the dominant sentiment, money flows into safe assets such as US Treasuries and the US Dollar and out of the riskier assets.

Once this relationship between assets that move in the opposite direction from the US Dollar is known, a chart that watches the movement of the markets can be constructed. The 5 minute chart below is an example of a small time frame correlation chart used for timing entries that overlays gold, oil, and the Russell 2000 Small Cap index on a chart with the US Dollar index. On 7-14-09, the US Dollar index began to sell off around 1:00 PM EST. Around the same time, the commodities markets represented by gold and oil, and the US equity markets represented by the Russell 2000, began to rally. On 7-15-09, the US Dollar selloff continued as the US equities markets had one of their best days in 2009, rising 3% for the day, while oil rebounded from recent selling, and gold had a similar strong performance. When a trader looks at a chart similar to this one, it is possible to track where the hot money is flowing visually, without trying to process all the reasons for the flows.


Figure 1

Other currencies can be substituted for the US Dollar index such as the Japanese Yen. In addition to the US Dollar, hot money has been flowing in the Yen as a safe haven currency when worldwide equities fall. If a trader brings support and resistance analysis into the picture, even better timing decisions can be made. The chart below, which overlays the Japanese Yen (@JY) with the E-mini S&P 500(@ES), shows the @JY testing the 1.09 weekly resistance area on 7-13-09, at the same time that the @ES was testing the 865.00 weekly support area. With both markets at extremes, a reversal can be anticipated.

For currency, equity, and commodity traders, knowing why markets move inversely, and watching charts showing inverse correlation movements between these markets can provide clues as to the sentiment of large speculators trading these markets. Any clues that improve trading results is good news. The bad news is for the US consumer who has to live with the effect of a weak dollar, and the rise in the commodities as a result, but that is the subject of a future newsletter.


Figure 2

Steve Misic – smisic@tradingacademy.com

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.