Oil, Gold & Bonds Correlations

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Introduction

In this section we'll pass judgement on the price action correlation that exist between currencies, gold, commodities and the fixed income markets.  What makes one go up, may make another go down.  What makes the second go up may make a third go up and what makes the third go down may make the first go up.  Markets are more than often inter-related and sometimes not as you would expect.

Gold and Currency Correlation

In the past Gold was the safe haven.  In times of economic turmoil everyone flocked to Gold.  This isn't necessarily so now-a-days.  Gold is no longer The Worlds reserve currency and investors now swerve towards safe currencies in troubled times.  Traditionally the safe haven currencies have been USD, JPY and EUR, although at the time of writing (European sovereign debt crisis - Late 2011, early 2012) the safe EURO is tinkering with disaster - we'll see how that pans out... These 'safe' currencies have a negative correlation with the Gold price.  

In flourishing economic periods Gold becomes the investment of choice along with more riskier assets like stocks etc.  One reason for this is to hedge against high inflation, as Gold tends to more than keep it's value in high inflationary periods.  Currencies that have a strong positive correlation with Gold also become flavour of the day.  These currencies have a strong relationship with Gold, either by mining or having a good proportion of reserves held in Gold.   

So why do Gold mining countries currencies appreciate in good times?  When a country imports more than it exports, the value of its currency will decline. On the other hand, the value of its currency will increase when a country is a net exporter. Thus, a country that exports gold or has access to gold reserves will see an increase in the strength of its currency when gold prices increase. AUD (Aussie Dollar), CAD (Canadian Dollar), ZAR (South African Rand) are all gold mining currencies and CHF (The Swiss Franc) has 25% of it's reserves held in gold. All have a positive correlation to gold prices.

The relationship between Gold and currencies isn't 100% though.  AUD correlation to Gold is said to be as high as 80%.  An example - In times of high demand from an industry that requires gold in it's production process the gold price will probably increase, while the currency may decrease for some other reason.  An Australian natural disaster may initially devalue the currency, as investors flee to safer havens.  This is an extreme example, but similar less dramatic events do happen on a regular basis, so be warned.

Oil and Currency Correlation

I'm sure we're all aware that Oil increases in value in good economic times and decreases in value during recessions - It's a pure demand and supply play.  Canada is a great oil producer and exporter, so when the price of oil shoots up, it's trade balance increases.  For importers like the The USA to buy Canadian oil they must pay in Canadian Dollars, which pushes up demand for The Canadian Dollar - CAD rises against USD.  Many FX traders will short USD/CAD as oil increases in price.  

Bonds and Currency Correlation

The ebb and flow of Bond yields has a strong correlation with world stock markets and currency indices.  In times of concern the demand for Sovereign bonds increases driving bond prices higher.  Inversely bond yields decline.  Safe haven government bonds include The German Bund, The UK Gilts and The US Treasuries. Investors feel insecure about where to park their hard earned cash, so they 'lend' their money to safe countries governments with the knowledge they will receive a yield and get their money back on bond maturity.  This is the same principle as buying safe currencies as discussed above, so we can see a correlation between declining bond yields (Increased demand) and increased demand for safe currencies.   

However, Bond yields also indicate future interest rate decisions.  A rising bond yield means interest rates are likely to be increased in the future and this is bullish for the currency.  You must understand the reason for government bond demand - safe haven or interest rate increase expectation.  

Using The Carry Trade with Bond Spreads

We'll go on to talk about the Carry Trade in more depth here.  For now though, let's take a sneak preview.  The bond spreads that occur between different economies can point to interest rate change expectations.  By monitoring these spreads we can form an opinion on where currency pairs are heading. As the bond spread between two economies widens, the currency of the country with the higher bond yield appreciates against the other currency of the country with the lower bond yield.

In the below example we can see the 10 year bond spread between Australian Bonds and US Treasuries and the positive AUD/USD correlation.  This chart is just one example of the strong relationship between bond spreads and currency pairs.  If taking advantage of the Carry Trade and all other technical's suited your strategy, we can see how the AUD appreciates against USD as the bond spread widens

Correlation between 10 Year Bond Yield Spreads and Currency Pairs

Notice how the bond yield spread Leads the currency pair - Bond Spreads are a leading indicator of currency pair future price action!!!  The general rule is when the 5Y or 10Y yield spreads widen in favor of a certain currency, that currency will appreciate against other currencies. But, remember, currency movements are impacted not only by actual interest rate changes but also by the shift in economic assessment or plans by a central bank to raise or lower interest rates.

The Equity-Forex Correlation

We can use worldwide equity markets to "guide us" in the movements of the forex markets. At a fundamental level when we buy stocks we need to buy them in the local currency, so if we want to buy Siemens on the Frankfurt Stock Exchange, we must first buy Euro's. If one economy is performing better than another, money will flow to the good economy and out of the bad one. The "general" idea is: strong stock market, strong currency; weak stock market, weak currency.  The USD and JPY however, have been following a different path over the last few years as we'll explore below.

When a domestic equity market rises, confidence in that specific country grows, leading to an inflow of funds from foreign investors. This tends to create a demand for the domestic currency, causing it to rally versus other foreign currencies.  Alternatively, when a domestic equity market falters, confidence declines, causing investors to convert their invested funds back into other currencies.

However, it's not that simple!  It's not always the case that when equity markets do well the currency does well. The correlation is imperfect as policy and events can get in the way.  For instance, it may be policy to keep currencies low against their counter-parts, thus promoting their own exports and keeping their economy competitive.  Their may be an increase in an equity market, but not a corresponding increase in the economy.  For instance if The S&P 500 appreciates it may not be on US activity.  Full of multi-nationals, The S&P 500 may be making their profits abroad.  Many other factors can disrupt this correlation, but in general it does hold.

USD & JPY - Safe Haven Currencies

One other factor that may disrupt that positive correlation is the existence of safe haven currencies. The Yen, along with the U.S. dollar, are considered to be safe havens amongst the major currencies. Whenever confidence in the global economy is down and traders are fearful, we typically see traders take their money out of the stock markets, which leads to a drop in the values of the DAX and S&P500. Fearful investors tend to head towards The USD as the worlds reserve currency or The JPY.  

You can measure these correlations yourself.  See our lesson on Currency Pair Correlations for more on how to calculate the correlation.

To Sum Up

You can either trade the correlations of the above financial instruments with currency pairs or many brokers allow you to trade Gold, Oil, bonds etc...  Their own platforms may chart these, or timingcharts.com can be used.  Remember when picking currency pairs use the technical analysis you've learned in previous modules and don't forget The Carry Trade.

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

More...


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Introduction

In this section we'll pass judgement on the price action correlation that exist between currencies, gold, commodities and the fixed income markets.  What makes one go up, may make another go down.  What makes the second go up may make a third go up and what makes the third go down may make the first go up.  Markets are more than often inter-related and sometimes not as you would expect.

Gold and Currency Correlation

In the past Gold was the safe haven.  In times of economic turmoil everyone flocked to Gold.  This isn't necessarily so now-a-days.  Gold is no longer The Worlds reserve currency and investors now swerve towards safe currencies in troubled times.  Traditionally the safe haven currencies have been USD, JPY and EUR, although at the time of writing (European sovereign debt crisis - Late 2011, early 2012) the safe EURO is tinkering with disaster - we'll see how that pans out... These 'safe' currencies have a negative correlation with the Gold price.  

In flourishing economic periods Gold becomes the investment of choice along with more riskier assets like stocks etc.  One reason for this is to hedge against high inflation, as Gold tends to more than keep it's value in high inflationary periods.  Currencies that have a strong positive correlation with Gold also become flavour of the day.  These currencies have a strong relationship with Gold, either by mining or having a good proportion of reserves held in Gold.   

So why do Gold mining countries currencies appreciate in good times?  When a country imports more than it exports, the value of its currency will decline. On the other hand, the value of its currency will increase when a country is a net exporter. Thus, a country that exports gold or has access to gold reserves will see an increase in the strength of its currency when gold prices increase. AUD (Aussie Dollar), CAD (Canadian Dollar), ZAR (South African Rand) are all gold mining currencies and CHF (The Swiss Franc) has 25% of it's reserves held in gold. All have a positive correlation to gold prices.

The relationship between Gold and currencies isn't 100% though.  AUD correlation to Gold is said to be as high as 80%.  An example - In times of high demand from an industry that requires gold in it's production process the gold price will probably increase, while the currency may decrease for some other reason.  An Australian natural disaster may initially devalue the currency, as investors flee to safer havens.  This is an extreme example, but similar less dramatic events do happen on a regular basis, so be warned.

Oil and Currency Correlation

I'm sure we're all aware that Oil increases in value in good economic times and decreases in value during recessions - It's a pure demand and supply play.  Canada is a great oil producer and exporter, so when the price of oil shoots up, it's trade balance increases.  For importers like the The USA to buy Canadian oil they must pay in Canadian Dollars, which pushes up demand for The Canadian Dollar - CAD rises against USD.  Many FX traders will short USD/CAD as oil increases in price.  

Bonds and Currency Correlation

The ebb and flow of Bond yields has a strong correlation with world stock markets and currency indices.  In times of concern the demand for Sovereign bonds increases driving bond prices higher.  Inversely bond yields decline.  Safe haven government bonds include The German Bund, The UK Gilts and The US Treasuries. Investors feel insecure about where to park their hard earned cash, so they 'lend' their money to safe countries governments with the knowledge they will receive a yield and get their money back on bond maturity.  This is the same principle as buying safe currencies as discussed above, so we can see a correlation between declining bond yields (Increased demand) and increased demand for safe currencies.   

However, Bond yields also indicate future interest rate decisions.  A rising bond yield means interest rates are likely to be increased in the future and this is bullish for the currency.  You must understand the reason for government bond demand - safe haven or interest rate increase expectation.  

Using The Carry Trade with Bond Spreads

We'll go on to talk about the Carry Trade in more depth here.  For now though, let's take a sneak preview.  The bond spreads that occur between different economies can point to interest rate change expectations.  By monitoring these spreads we can form an opinion on where currency pairs are heading. As the bond spread between two economies widens, the currency of the country with the higher bond yield appreciates against the other currency of the country with the lower bond yield.

In the below example we can see the 10 year bond spread between Australian Bonds and US Treasuries and the positive AUD/USD correlation.  This chart is just one example of the strong relationship between bond spreads and currency pairs.  If taking advantage of the Carry Trade and all other technical's suited your strategy, we can see how the AUD appreciates against USD as the bond spread widens

Correlation between 10 Year Bond Yield Spreads and Currency Pairs

Notice how the bond yield spread Leads the currency pair - Bond Spreads are a leading indicator of currency pair future price action!!!  The general rule is when the 5Y or 10Y yield spreads widen in favor of a certain currency, that currency will appreciate against other currencies. But, remember, currency movements are impacted not only by actual interest rate changes but also by the shift in economic assessment or plans by a central bank to raise or lower interest rates.

The Equity-Forex Correlation

We can use worldwide equity markets to "guide us" in the movements of the forex markets. At a fundamental level when we buy stocks we need to buy them in the local currency, so if we want to buy Siemens on the Frankfurt Stock Exchange, we must first buy Euro's. If one economy is performing better than another, money will flow to the good economy and out of the bad one. The "general" idea is: strong stock market, strong currency; weak stock market, weak currency.  The USD and JPY however, have been following a different path over the last few years as we'll explore below.

When a domestic equity market rises, confidence in that specific country grows, leading to an inflow of funds from foreign investors. This tends to create a demand for the domestic currency, causing it to rally versus other foreign currencies.  Alternatively, when a domestic equity market falters, confidence declines, causing investors to convert their invested funds back into other currencies.

However, it's not that simple!  It's not always the case that when equity markets do well the currency does well. The correlation is imperfect as policy and events can get in the way.  For instance, it may be policy to keep currencies low against their counter-parts, thus promoting their own exports and keeping their economy competitive.  Their may be an increase in an equity market, but not a corresponding increase in the economy.  For instance if The S&P 500 appreciates it may not be on US activity.  Full of multi-nationals, The S&P 500 may be making their profits abroad.  Many other factors can disrupt this correlation, but in general it does hold.

USD & JPY - Safe Haven Currencies

One other factor that may disrupt that positive correlation is the existence of safe haven currencies. The Yen, along with the U.S. dollar, are considered to be safe havens amongst the major currencies. Whenever confidence in the global economy is down and traders are fearful, we typically see traders take their money out of the stock markets, which leads to a drop in the values of the DAX and S&P500. Fearful investors tend to head towards The USD as the worlds reserve currency or The JPY.  

You can measure these correlations yourself.  See our lesson on Currency Pair Correlations for more on how to calculate the correlation.

To Sum Up

You can either trade the correlations of the above financial instruments with currency pairs or many brokers allow you to trade Gold, Oil, bonds etc...  Their own platforms may chart these, or timingcharts.com can be used.  Remember when picking currency pairs use the technical analysis you've learned in previous modules and don't forget The Carry Trade.

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

More...


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