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Is forex trading affected by stock market volatility?

Posted: 14 June 2022 10:00 am
News
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What are the links between a country's stock market and its currency value?

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CFDs and forex are risky investment products and most clients lose money trading. Consider whether this is right for you before making a decision.

Equity markets (shares) typically go through highs and lows – as investors have experienced during the coronavirus pandemic over the last 2 years.

Fast forward to today and things haven't improved, with global indices such as the US S&P 500, the Nasdaq 100 and even our own S&P ASX 200 rocked by the conflict in Europe, rising inflation and surging commodity prices.

Today alone, the ASX 200 fell 3.55%, while the Dow Jones, S&P 500 and Nasdaq 100 fell 2.8, 3.9 and 4.7% with investors fearing the US economy will go into a recession.

As such, investing through stock market volatility becomes challenging even for the most experienced investors, with many choosing to stay on the sidelines with their cash until the volatility passes.

Even wise investors may tend to ignore the foreign exchange (forex) market because it's perceived as risky. In reality, it's far less volatile and continually provides opportunities for active investing.

Are stock and forex markets linked?

Generally speaking, stock and forex markets are completely different financial markets.

The former is where stocks – representing ownership in individual companies – are bought and sold. It tends to be centralised and broadly related to companies from one particular country or region.

Foreign exchange tends to be traded in a decentralised, international marketplace where the currencies of different countries and related instruments are bought and sold.

Forex trades involve an equal exchange of assets, meaning it always involves pairs of 2 different currencies such as the US dollar against the Australian dollar or the US dollar against the Japanese yen.

Despite this basic distinction, both markets often show correlated movements.

In theory, when a particular stock market rises, confidence in that country grows, leading to an inflow of funds from foreign investors. This creates demand for that country's currency, causing it to rally against other foreign currencies.

On the flip side, when an equity market performs badly, investors look to shift their funds to other foreign markets, resulting in selling pressure on the local currency.
The correlation between the stock and forex markets can be either positive or negative. If positive, it shows both markets appreciating or depreciating in tandem. When negative, it indicates an inverse movement in one market in relation to the other.

To take an example, consider Australia's leading share market index, the ASX 200 and its link to the AUD/USD pair (the Australian dollar against the US dollar).

According to Aaron Hill, an analyst at Australian forex provider FP Markets, there has been a clear correlation between the ASX 200 stock index and the AUD/USD currency pair since the beginning of the pandemic in March 2020.

"Based on a 60-day rolling correlation, an almost perfect correlation (0.96) emerged in July 2020. A similar scenario is seen with the NZD/USD pair (the New Zealand dollar against the US dollar) and the ASX 200," he says.

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AUD / USD chart. "It's common to see the AUD/USD and NZD/USD experience volatility. The USD/JPY can also see sizeable movement," says FP Markets analyst Aaron Hill.

What factors affect correlation?

There are a number of practical factors that determine whether a significant stock and forex market correlation exists.

1. Economy. Generally, the better the health of a country's economy, the more its stock markets will rise as individual companies report higher revenue and better profits. This also tends to increase demand for that currency relative to other currencies, which can lead to a visible forex stock correlation.

For instance, the broad US stock market typically shows a positive correlation with US dollar-based currency pairs, largely based on the performance of the US economy.

2. Exports. Some currencies are affected by commodity prices because of the industries located within the country being substantial importers or exporters of those commodities. This in turn also has a bearing on corporate profits, which is reflected in the performance of the stock market.

For example, if the price of a commodity like iron ore or coal that Australia exports increases significantly, then the Aussie dollar also tends to appreciate. Currencies of other resource-based economies, such as Canada and New Zealand, also demonstrate similar patterns.

3. Govt/central bank policy. The value of a country's currency is largely influenced by the government's balance sheet, its central bank's monetary policy and interest rate changes. These in turn also have a bearing on the performance of companies operating in that country.

4. International companies. The stock price of companies with considerable overseas operations and foreign currency exposure, such as multinationals like Nestle, Procter & Gamble or Apple, can be influenced by substantial movements in the forex market, and this directly affects their bottom line.

For example, the AUD-USD exchange rate has a significant bearing on the profitability of Australian companies that do a considerable amount of business overseas. If the Aussie dollar shows significant strength, then profits from their foreign operations tend to decline, which in turn has a negative effect on the price of their stock.

Many brokers offer a trial account so you can test your trading strategies.
For instance, FP Markets offers a free 30-day demo account with $100k USD virtual funds to grow your experience, prior to trading live.
Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, CFDs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading CFDs and forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades.

Using forex-stock correlations

The stock and currency markets often influence each other, but this does not happen all the time and finding a reliable indicator is often difficult.

Using forex-stock correlations as trading opportunities works better on an individual stock basis, particularly in the case of large publicly-traded companies with substantial overseas operations and significant foreign-exchange exposure.

Where global companies invest is often a leading indicator of where they see potentially strong economic growth.

Again, where there is strong economic growth, usually greater demand for the currency will follow.

The hedging strategies that multinational corporations reveal in their earnings reports are a good signal of the future outlook of currency fluctuations.

Another way to determine the correlation between forex and equity markets is to be alert to instances of countries weakening their currency to favour local exporters, which will help fuel growth and profits and in turn boost performance in that local stock market.

The bottom line

While there is not a direct correlation between forex and equity markets, they certainly impact each other.

And while they aren't directly related, being aware of how both financial instruments work and their impact will only make you a more effective trader.


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