Forex / Financial markets correlation

On the Forex, the different exchange rates can be strongly linked each other, but they can also be linked to other markets like shares or raw material.

Numerous are the correlations with a fundamental reason.

Here are some correlations at the beginning of 2009 between the Australian dollar, the Canadian dollar, the CRB (a material raw basket), the Dow Jones (a share index), gold and oil (data from:  dailyfx.com) :

The observation of these correlations shows that most of them are quite high so non negligible. One of the explanations of these correlations is for example the fact that countries like Australia or Canada are great raw material exporters; their incomes are directly impacted by the raw material rates evolution; this tends to have an influence on their exchange rates.

But, in general, the main reason of these correlations is the risk aversion. In fact, it is possible to classify the different assets class according their risk level. Funds manager will make their portfolio weighing fluctuate according to the economic sentiment. The more the economy will seem to be to them in good health, the more they will be interested in risky assets, because they are more lucrative during an economic growth stage. The less risky assets are liquidities, guaranteed capital investments, gold (overall in case of forecasted inflation period), treasury bills…. The most risky assets are emerging countries shares, small cap shares, raw material….

Among currencies, a classification is also possible. One the one hand, the dollar is still the safe currency and will tend to increase during the less auspicious economic periods. On the other hand, the “risky” currencies will tend to increase when the economy is well. This is true for all the currencies except the dollar: the Euro, the Pound sterling… The yen has a special status because it is turning into the safe currency now.

To sum up, when the economic health seems to be good, stock exchanges increase, raw material increase and dollar decreases. The currency crosses with the uncertain dollar (on the right) like the EUR/USD, the GBP/USD…will tend to increase; we can see it on the following graph that compares the Dow Jones to the EUR/USD :

Nevertheless, the comparison of the two curves shows some divergences that will be interesting to observe during the end of trends because a market will probably turn around the other, giving in this way an interesting index on the future evolution of rates.

The dollar index (or $index) builds by comparing the dollar evolution in view of a currency basket (euro, yen, pound sterling, Canadian dollar…) will be able to give the dollar trend. This $index will also be interesting to be observed in parallel of certain major currency crosses that includes dollar like the EUR/USD or the GPB/USD  because it is possible to apply the same confirmation  principle that the one Charles Dow used.  The Dow Theory creator used this confirmation principle with its indexes Rail Average and Industrial Average. According to his theory, we have to notice a signal on the two indexes to enter in position in order to avoid what we called false signals. The same principle can be used on the Forex, with the $ index as a confirmation.

The study of the correlations between different markets is not an easy thing but this can help to understand some financial systems and capital flows. It will also be interesting for investors that intervene on several markets at the same time, to look at it in order to be able to build an efficient diversification.