Financial markets as we know them today move in a correlated manner. Though the correlation degree, differs from market to market.

In some cases, two or more markets move in a direct correlation fashion. Some other in an inverse relationship. Therefore, the risk of getting it wrong on one market multiplies on other markets too, leading to one of the biggest mistakes in Forex trading: overtrading.

For this reason, the need arises to analyze different markets before taking a position in the Forex market. Correlations are of two types:

• Internal correlations – different currency pairs correlate due to the factors causing their moves. For example, in a risk-on or risk-off move, the EURUSD, GBPUSD, AUDUSD and NZDUSD move in the same direction, traveling almost the same distance. Therefore, trading one of the four pairs is like trading any other pair, with the risk being to overtrade.

• External correlations - the subject of this article, external correlations refer to Forex trading currency pairs correlating with other markets.

It would be fair to say here that traders look at both internal and external correlations before deciding to buy or sell something. It is like using both technical and fundamental analysis before buying or selling an asset.

Intermarket Analysis in Forex Trading

Before anything, correlations refer to a specific period. And, trading them is tricky because you never know how the correlation degree changes and when.

Sometimes it follows an invisible logic. Some other times, just because the correlation is supposed to exist, it doesn’t mean that the market will move in that direction.

The idea of using intermarket analysis in Forex trading is to avoid unnecessary risks. One risk is to be wrong when buying or selling a currency pair. But, that decision may affect other potential trades, due to the markets being correlated.

The JPY and Risk-On/Off Moves

Japan is the home of unconventional monetary policy decisions. Faced with decades-long deflation, Bank of Japan went to extreme lengths to lift the economy from the black-hole in which it sank.

As a reminder, when inflation turns negative, consumers postpone the buying decision indefinitely. Studies show that certain inflation levels lead to economic growth, and therefore the consensus is that central banks target a two percent inflation level.

The problem is that sometimes economic principles don’t work. Japan, with its aging population and a culture that makes immigration difficult, puts capitalism to extremes.

In Forex trading, the JPY (Japanese Yen) is one of the most traded currencies. First, it belongs to one of the largest economies in the world. Flows out of and into the JPY can sharply move prices.

Second, it enjoys flows from correlated markets, as trading algorithms buy or sell JPY pairs when risk-on/risk-off news influences markets.

The rule of thumb goes that a risk-on move translates into higher equities and lower JPY. And, during a negative round of economic news or geopolitical events, the JPY strengthens.

The perfect example came from the recent North Korean showdown from the start of 2018. The nuclear tests made on the North Korean peninsula made traders buy the JPY in the flight for safety.

Logic doesn’t make sense anymore. For example, why would anyone buy the currency of a country (JPY) threatened with extinction by missile targeting? And yet, this is what happened, and not once, but every single time a missile was launched or tested.

Apparently, the stock market tanked every time, with the correlation proven to be alive and well. Hence, having a position on any JPY pair and on a stock index will hit a trading account twice, if wrong.

Commodities and Forex Trading

Nowadays Forex brokers offer more than just currency pairs in a trading account. Since the introduction of CFD’s (Contracts for Difference), Forex traders have access to different markets from the same trading account.

CFD’s open the door to a plethora of opportunities, like trading commodity markets for instance. Silver, gold, oil, and so on, enjoy decent volatility levels, being suitable for various trading strategies.

But one thing about commodities is that they depend on the supply and demand imbalances. Contrary to currencies, one cannot print more gold, or oil, etc. Hence, discoveries, their location, the difficulty to bring the commodity to the market, and so on, are significant enough to influence the volatility of the market.

However, trading commodities differ than trading currencies. Even famous trading theories stop working in the face of news adversity.

Imagine trading oil. As the one product that completely changed our societies, oil is the subject of major political decisions on the global stage. Oil is money and money is power, or so they say.

OPEC (Organizations of Petroleum Exporting Countries) meetings are carefully scrutinized by Forex and oil traders alike. The power to shut down production levels or to increase the output capacity often leads to market ranges until the news comes out.

It makes trading oil a news dependent activity, but the same can be said with the currencies directly related to oil. Or correlated, like the Canadian Dollar (CAD).

As one of the most traded currencies in Forex trading, the Canadian Dollar (CAD) depends on what happens with the oil price and with the overall oil industry. Hence, Forex traders check the economic calendar to see when OPEC meets again, what is the price of oil, if there is any bullish or bearish pattern to affect it, etc. They’ll all influence the volatility and direction of the CAD pairs in Forex trading.

But then the CAD and the Australian Dollar (AUD) move in an inversed manner. While mostly an inter-market correlation, the AUD depends on the gold market.

As a significant gold producer, Australia employs many in the mining industry. Changes in the price of gold make mining more expensive or cheaper, thus affecting the profitability of the mining process.

Plus, the process becomes more and more expensive as the “easy gold” already has been mined all over the world. Nowadays, mining companies dig deeper and deeper into the ground to bring the yellow metal to the surface.

But gold depends on supply and demand too. From central banks to demand from the jewelry market and other industrial uses, the price of gold may turn dramatically.

Even AUD depends on other factors besides the gold market. For instance, it fluctuates heavily with changes in the Chinese economy.

Because Australia is a major exporter to China, when the Chinese economy slows down or expands their economic activity, the first market to react is the AUD in Forex trading.

Conclusion

This article aimed to point out the interconnectivity between different financial markets. Obviously, the logical conclusion is that financial markets as a whole matter more than a single one.

Depending on the trading style, a trading account is more or less affected by the correlation degrees experienced in different markets. But even scalpers (traders that buy and sell multiple trades for short-term profit) have a hard time trading a market without considering correlations with other related markets.

All in all, we have discussed the basic correlations here, covering the most popular markets that relate to Forex trading. Other associations do exist, that involve markets like regular options expiries, the relationship between bonds and their yields, and so on, and we’ll discuss them in upcoming articles.