Taking Your FX Cues from Intermarket Analysis: Can Other Markets Provide Guidance for Trading Forex? You Have to Watch Them with a Close Eye and Apply the Right Analysis Tools to Know How Much You Can Trust Them-If You Can Trust Them at All
Luca, Cornelius, Modern Trader
Traders like to complain. A common complaint is that the reaction to the U.S. unemployment data, released on the first Friday of every month, is greater in the bond market than in the currency market. And how many times have you searched for the impact of the surging oil, gold or other commodity prices on the Australian or New Zealand dollars? With the Chinese economy burgeoning, the commodity currencies have been in great demand, but what keys in other markets should you look for?
The equity and fixed income markets tend to have a more powerful reaction to economic reports, as they have a more domestic focus. The foreign exchange markets are likely to emphasize the difference between two different economies. In the example of the U.S. unemployment report there is an additional problem: Currency and fixed income markets are open during the release but equity markets are not, so they can't react immediately.
Assuming all markets are open, they tend to follow a pattern in reacting to reports: interest rates first, then the equity markets; as a hike in interest rates, for example, might negatively impact stocks. If the forex market perceives this scenario as correct, then the dollar will likely face some weakness on expectations that the reduced demand for stocks will translate into a drop in demand for the U.S. currency.
"Shifting focus" (right) shows the changing correlations between the euro futures and oil futures. The two futures contracts moved fairly similarly, as they both declined. But while oil prices, boosted by Chinese industrial demand, surged to new highs, the euro kept on pushing lower. This divergent price action lasted more than a month and then once again, euro and oil futures got in sync and dipped together.
Financial markets consist of four areas: currencies, commodities, stocks and interest rates. Gauging the correlations between these four sectors is a never-ending undertaking, and only one thing is for sure: They just don't continue at the same level forever, even when the underlying economic environment remains unchanged.
Stocks and bonds usually trend in the same direction, particularly in a low interest rate environment, in which equities can grow. Meanwhile, commodity prices likely trade opposite the dollar. Inflation hurts the bond market and traders look at the CRB index for inflation cues. If commodity prices trade higher, then the market expects higher interest rates to slow inflation, which means lower bond prices.
These common scenarios don't always hold true. These will be the times to find out which market will give way to bring the general correlation back in line.
Fundamental analysis is useful in this case, but its macro horizon leaves many loose ends. Determining which markets will most likely impact forex markets is not easy, but technical analysis can help. Technical analysis tools are easily transferable from sector to sector. Traders then will have to identify the strongest market from these four sectors and attempt to figure the path and timing the weaker markets will take while following the leader.
Take a look at the chart in "Keying in," (below). The Dow Jones Industrial Average had been trading upward since April, while the dollar/yen started its climb in early May. This twin up move occurred during the continuous tightening by the Federal Reserve, and with a consensus tightening would continue.
The stubborn, if choppy, strength of the stock market meant that traders gauged U.S. inflation to be engrained deeply enough to warrant further rate hikes and the economy to be sufficiently strong to sustain the impact of higher rates and record-breaking oil prices.
Prior to May 19, dollar/yen, oil and the Dow were all heading higher, but only the dollar/yen and oil prices showed a close correlation. While the dollar/yen's move was not the longest, it was the cleanest and showed the least propensity to make a corrective decline. …