When you first decide to enter the financial marketplace, there’s always a great deal of emphasis placed on cultivating a diverse trading portfolio. While this is an important consideration, however, it’s also crucial that you determine the relationship that exists between different marketplaces and determine which are the most seminal.
Take the ties that bind stock markets and the foreign exchange, for example, as these two vast entities have been at the centre of a chicken-and-egg dilemma for more than a generation now. Do stocks and equities call the shots that impact on currency trading, or is the volatile and liquid forex market a dominant driver of trends and momentum?
In this post, we’ll strive to answer this question and explore the complex relationship that exists between stocks and forex.
The Basic Rule that Binds Stocks and Currencies
In fundamental terms, there is a basic, underlying rule that charts the theoretical relationship between stocks and currencies.
More specifically, when domestic equity markets and stocks rise, so too does the level of confidence and positive sentiment within the country. This is thought to have drive higher levels of overseas investment, which in turn creates a more considerable demand for that nation’s currency.
Conversely, the decline of a domestic stock market leads to diminished confidence and causes investors to seek flight, while trading capital is subsequently invested back into alternative currencies. As a result, the demand for a specific currency falls while it’s value in the global also begins to depreciate.
Why Theory does not Always Translate into the Practical Marketplace
While this rule makes perfect sense in theory and often translates well into practice, this has not always been the case throughout history. In fact, if you chart the historical relationship between the U.S. Dollar (USD) and the S&P 500 Index over the course of the last 20 years, you’ll see that these entities have moved together, shifted in opposite directions and witnessed completely unrelated fluctuations at various times.
This does not mean that the basic principle is completely flawed, of course, but it does raise potential variables that undermine the correlation between markets in some instances.
The relationship often varies from one international stock market to the next, for example, as this has been borne out by seminal political events during the last two years. When Donald Trump was elected as U.S. President, we saw U.S. stocks rally and the USD gain 3% on the back of former real estate mogul’s “America first” policy, thanks largely to the fact that S&P 500 firms generate 70.4% of their revenues from the domestic market. Clearly, a buoyant S&P 500 often heralds increased earnings for brands, which in turn boosts the value of the USD and the demand that exists for this currency.
If this explains why the S&P 500 and the USD often move in harmony, however, the same cannot be said for the FTSE 100 in the UK. In this instance, the vast majority of FTSE 100 companies generate their revenues from outside of the UK, meaning that the infamous Brexit vote of 2016 sent the value of sterling tumbling by 12.8% against the USD while the FTSE 100 rose by a staggering 10.4% in just three months. In short, the nature and structure of this equity market makes it less likely that the value of stocks and currency will shift in harmony.
Understanding When Markets will Correlate and when they Wont
Similarly, the issue of balance remains an important consideration in the relationship between stocks and currencies. After all, if a domestic currency grows disproportionately, this could have a negative impact on exports and undermine the stocks of firms who generate their income by selling products or services overseas.
These are just two of the many variables that impact on the relationship between stocks and currencies, and ultimately it’s your ability to comprehend these and identify when market movements are likely to correlate that will determine your success or failure as a trader.
This is why knowledge and understanding remain key weapons in the modern traders army, as you look to create a balanced and diverse portfolio that reflects the macroeconomic climate.