Market turbulence this year has made it more challenging for traders to separate the noise from the signal. The globalization of sentiment has generated correlation among sectors. Problems in the Eurozone cascade into U.S. markets every week. Currencies have responded with a vengeance, as the mood of the market has shifted from euphoria to regret and returning to fear. The resulting uncertainty has caused "safe-haven" responses in the U.S. dollar, gold and the yen. These conditions make inter-market analysis more important than ever.
To gain greater granularity about these complex forces affecting prices, traders should look closely at the relationship between equities and currencies. The fundamental forces that cause currency valuations to change also cause equity valuations to do the same. There is no place to hide. The question arises: How can the forex trader improve his inter-market analytical skills? While we can’t track all of the currencies here, we can pinpoint some major inter-market currency and stock co-movements that can be useful to traders. We will review the Australian dollar (AUD/USD), Japanese yen (USD/JPY) and Canadian dollar (CAD/USD) and pinpoint their most relevant equity partners.
The Aussie is a good place to start because its valuations are triggered by global commodity market conditions. Strong growth in the global economy, particularly in China, often translates to higher demand for Australian resources. Instead of tracking demand for a large basket of commodities to measure Aussie prospects, a trader can track Freeport-McMoran Copper & Gold (FCX). Freeport is the world’s largest publicly traded copper company. It is projecting 2011 sales of about 3.8 billion lbs. of copper and 1.6 million ounces of gold, which makes FCX’s correlation with the Aussie among the closest of any equity-currency pair (see "Follow the copper"). The correlation percentage reached 0.8 in November.
Let’s turn to some other currency/equity relationships. The strengthening yen has generated several interventions by the Bank of Japan this year, which in turn has led to rallies in Japanese equities. Traders looking to evaluate the prospects of USD/JPY should pay close attention to Sony’s (SNE) price action. While it isn’t always clear which is leading and which is following, a stronger yen has had a chilling effect on Sony and bullish Sony’s price action may be an early signal of a weakening yen.
The Canadian dollar is impacted both by expectations on crude oil prices as well as U.S. growth. Approximately 80% of Canadian exports are to the United States, generating an intimate linkage to the loonie. When crude oil prices increase, the loonie strengths against the U.S. dollar. Also, when the S&P 500 strengthens, it generates increased confidence in greater demand for Canadian exports, and the Canadian dollar also increases (see "Birds of a feather"). Note that the chart shows the loonie prices in dollars.
Overlaying a currency price chart with the chart of its key equity partner provides the trader a quick visualization of conditions. But there is more than what is seen on the surface. Ask yourself what appears to be leading price action, the stock or the currency? Are patterns changing? Changes in their co-movements are important clues that the key fundamental conditions creating the correlations are shifting. Weekly chart patterns provide an effective level of robustness. The weekly pattern filters out the noise and lets the trader see larger changes. Another advantage of looking at key equities that track currencies is the ability of the trader to obtain a great deal more information about global conditions. Equities have extensive information about their company’s performance as well as forward-looking statements. Reading their quarterly 10k reports on a routine basis will provide insight into global economic conditions. In any case, it should be clear that just looking at the spot currency price is no longer enough.
It may take a bit more work for the currency trader, but a focus on the equity-currency connection is likely to give the forex trader an extra edge in these times of market globalization.
Abe Cofnas is the author of "Sentiment Indicators" and the forthcoming "Trading Binary Options: Strategies and Tactics" (Bloomberg Press). He can be reached at abecofnas@gmail.com.
