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How correlating markets impact forex trading

Market correlation is when the price of two or more markets moves together.

Market correlation is when the price of two or more markets moves together. Markets can correlate in a positive way: if the price of one asset goes up, then the price of another asset also goes up. Markets can also correlate in a negative way: if the price of one asset goes up, the price of another goes down.

The underlying reasons behind market correlations differ between markets. Identifying them can allow a trader to determine future price movements, within reason.

It is important to note that market correlations can break down if the wider economic environment experiences a shock or a change in circumstance, such as a financial crisis.

Capital moves between markets causing correlation

The easiest way to understand the principles behind market correlation is to think of the flow of capital between markets.

Positive correlation between Gold and the Australian dollar

The Australian dollar positively correlates with the price of gold. This is because Australia is a substantial producer of gold and exports it to the global market. In order to buy gold from Australian producers, a buyer must first convert the currency they are using into Australian dollars.

If the price of gold increases, a buyer of gold will then need to acquire more Australian dollars in order to purchase it. As there is now more demand for Australian dollars to buy the commodity, the value of the Australian dollar appreciates against other currencies. Hence there is a correlation between gold and the Australian dollar.

Negative correlation between the US dollar and Gold

Under normal market conditions, investors look to make money by investing capital into the financial markets, such as bonds and stocks in the US. These investments are considered risky due to the potential volatility and losses that can occur, however they can produce significant gains.

Under normal circumstances, there is a negative correlation between the US dollar and Gold

While gold is still valuable in these times, traditionally, investors may feel they can make higher returns by investing in the US equity market, resulting in less desire for gold. Consequently, capital flows away from gold and into US equities. US equities can only be purchased using US dollars and so when there is a rise in demand for US equities, there is also rise in demand for the US dollar and the US dollar increases in value. Hence there is a negative correlation between the US dollar and gold.

In times of economic uncertainty, investors may lose their appetite for risky assets, such as US equities or bonds, and seek to put their capital into safer assets, such as gold. Investors sell their risky assets and then gain US dollars to purchase gold on the world market. Demand for the US dollar has now declined whereas the demand and price of gold has risen. Hence, the value of the US dollar declines and the price of gold increases.

Market correlations can break down

There are times when the normal correlation observed between markets can break down.

To provide an example, let's revisit the correlation between the US dollar and gold. It has been established that during periods of economic downturn, investors and traders will seek a safer investment in gold and will sell the US dollar.

Market correlations can break down under abnormal economic circumstances. For example, under a crisis situation, investors may seek out safe investments in multiple assets, and could cause the usual correlation between assets to break down.

However, under abnormal circumstances, such as a crisis situation, this market behaviour may begin to break down. Economic conditions could become so bad that investors seek out safe investments in multiple assets, which may include US government debt, as well as gold. In order to purchase US government debt, US dollars must be acquired and so the dollar increases in value under increased demand. Gold, being a safe haven, increases in value under higher demand as well.

In this example, both the US dollar appreciates along with gold and so the inverse correlation breaks down.

Using market correlations to trade

A trader can use correlating markets to try and determine future price movements of one market based on the movement of another.

AUD/USD and Gold

Taking the example of the Australian dollar and gold, it is understood that in normal market conditions there is a positive correlation between the two.

Let’s say there are several reports of negative economic data regarding the economy of the United States. Investors may determine that the business environment has become more difficult to operate in and withdraw capital from the stock markets. Capital then flows away from the equities market as investors look to place their capital in other investments.

Investors understand that gold may be in demand as investors seek safer havens during market turbulence. Traders know that as Australia is a large producer of gold, the Australian dollar will likely increase in order to purchase the increasingly more expensive gold. Traders also understand that the US dollar will likely be sold to do so. As a result, the value of the US dollar is likely to decrease and the value of the Australian dollar is likely to increase.

Traders can then look for opportunities to buy the AUS/USD.

Oil and CAD

There is a positive correlation during normal market conditions between the Canadian dollar and crude oil.

The US is currently the world's number one consumer of oil. Canada is currently one of the worlds's largest exporters of oil. The Canadian economy is highly dependent on the US – 75% of Canada's total exports and almost all of its oil produce go to the United States.

Oil importers in the US have to use Canadian dollars to buy Canadian oil. When the price of oil increases, it takes more Canadian dollars to purchase the oil and so importers have to convert more US dollars into Canadian dollars. There is now more demand for the Canadian dollar and less demand for the US dollar, and so the Canadian dollar increases against the US dollar.

Opportunities can be found in the Canadian dollar, when it is believed that global circumstances will result in oil becoming more expensive. For example, a hurricane could force oil production in some parts of the United States to shut down. Because production has stopped, there is now less supply of oil. The demand for oil has not decreased and so the price of oil goes up, resulting in higher demand for the Canadian dollar as explained above. Traders can then look for opportunities to buy the Canadian dollar.

Stock markets and Swiss franc

There is a negative correlation under normal market conditions between the equities market and the Swiss franc.

The Swiss franc traditionally is seen as a safe haven, and so when there is a period of economic turmoil, investors seek to put capital into the Swiss franc instead of riskier assets, such as the stock market.

So if, for example, negative reports regarding the US economy are published, investors may withdraw capital from the US stock market and look to put their capital into safe havens such as the Swiss franc.

Investors will then buy the Swiss franc, which in turn increases in value under the heightened demand. So when a trader observes a decline in the US economy, a trader can look for opportunities in buying the Swiss franc against other currencies.

Summary

So far, you have learned that:

  • market correlation means that two or more markets move together.
  • positive correlation is when the price of an asset increases because the price of another asset increases.
  • an example of positive correlation can be seen between Gold and the Australian dollar.
  • negative correlation is when the price of one asset declines because the price of another asset increases.>an example of negative correlation can be see between the US dollar and gold
  • under abnormal circumstances, such as an economic or financial crisis, correlations between markets can break down.
  • traders can used market correlations for trading opportunities. If there is news published that is likely to affect a particular market, traders can look for opportunities in a correlating market.
  • an example of such an opportunity can be seen when the US economy is negatively affected, traders can look for opportunities in buying gold or the Australian dollar.