Find out what intermarket correlation is and how you can use it to inform your trading.
In this lesson you will learn:
- What correlations mean and how they can influence your trading
- Which markets could correlate with each other
- Why some commodities could have an impact on currencies
Financial markets are a system of connected vessels. If the value of bonds decreases or increases significantly, this can influence the price of currencies and stocks. It’s not a general rule, but there are some instruments that historically move in tandem. Why? Well, there are various reasons. The Canadian dollar is a perfect example. The currency is strongly correlated with oil as the latter has a significant impact on the Canadian economy. Let’s look at some popular correlations to see how they can be used in your trading strategies.
How do you measure correlation?
Correlation is one of the most common and most useful statistics. A correlation is a single number that describes the degree of relationship between two assets. It can be used for individual stocks or assets, or it can measure how broader markets move in relation to each other. It is measured on a scale of -1 to +1. A perfect positive correlation between two assets has a reading of +1. A perfect negative correlation has a reading of -1. However, such prints are extremely rare. Let’s take a look at a visual example.
As you can see, there’s quite a nice correlation between the Canadian dollar and oil. This is defined as a positive correlation, because both the markets are moving in tandem - in other words, one market increases as the other market increases, and decreases while the other decreases. Of course, it’s a general rule and a deviation from it could sometimes appear.
AUD vs. Iron Ore
The Australian dollar is a commodity currency, which means that its strength depends mainly on prices of specific commodities. Australia is the largest iron ore producer in the world and it should therefore come as no surprise that the economy's wealth and the value of its currency depends heavily on the prospects facing iron ore. Therefore the outlook for this commodity could well be taken as a proxy for the outlook facing the Australian Dollar.
For example, if the price of iron ore goes up, investors usually have to buy more Australian dollars to buy the same amount of iron ore from Australia. This increases aggregate demand for the currency which strengthens AUD.
NZD vs. Dairy Prices
Just like Canada, New Zealand is strongly dependent on prices of milk. Unlike oil or gold, milk isn’t a commodity that traders spend much time thinking about. What’s more, you’ll rarely hear a thing about dairy prices in TV or radio. It doesn’t mean, however, that milk isn’t crucial in trading the NZD.
It could be said that New Zealand is the Saudi Arabia of milk. It is the world’s largest dairy exporter that accounts for 40 percent of the international dairy trade. Dairy products make up 7 percent of the country’s total economic output. In addition, the world’s largest dairy exporting company, Fonterra, is also New Zealand’s largest company. So as you can see, a deterioration in milk prices could affect the whole economy, thus leading to a weaker currency.
When milk prices are high, importing countries usually need to buy more New Zealand dollars to buy milk from them. When milk prices fall, there is less demand for the New Zealand dollar, and so it can fall in value.
USD and Gold
Unlike in the cases of AUD and NZD, the US economy is not dependent on the prices of a specific commodity, in this case gold. However, a strong inverse correlation between the dollar and gold could be noticed. An inverse correlation, also known as a negative correlation, is a contrary relationship between two markets. So when one market increases in value, the other usually decreases. This is down to two important reasons:
- A falling dollar can increase the value of other currencies. This often increases the demand for commodities, including gold.
- When the dollar starts to lose its value, traders look for alternative sources to store value. That is because a fall in USD is usually connected with falling interest rates. As rates are lower, traders are searching for a yield elsewhere and gold could be an alternative.
As we can see on the chart below, gold was strongly correlated with inverted USDCHF. That means that as its price rose, the value of dollar fell.
However, one thing should be remembered. It is possible for the dollar and gold to increase at the same time. This may happen when a crisis or a deterioration in market sentiment could be seen. Such a scenario could push traders in search of traditionally ‘safe’ assets, including the dollar and gold.
Trading the Divergence
There are many instruments that are correlated with each other, so it’s almost impossible to present them all. For example, both dollar and gold are mostly dependent on the moves on the bonds market, while the Nikkei usually moves in tandem with the USDJPY. Oil weighs on the price of the Russian Ruble and the Norwegian Krone, while South African Rand (ZAR) is correlated with gold. We won’t focus on each one, but we could see how to use the correlation as a part of your trading strategy. Let’s get back to the last example. As we can see, there were periods when the USDCHF rate was higher or lower than the price of gold was indicating (highlighted with red vertical lines).
This is known as divergence between two instruments and could be used to open a trade. If you know that two instruments used to move in tandem then you’ll expect their prices to meet again in the future. So if USDCHF is higher than gold suggests, a trader could sell the pair and buy gold. However, one thing has to be noted: periods of divergence could last for longer, thus making such a trade painful.
Opportunities and Correlation
Intermarket correlation is an important part of the fundamental analysis. As previously mentioned, some commodities could have a significant impact on different currencies. On the other hand, some currencies such as the United States dollar could have an impact on prices of commodities. What’s more, periods of a divergence between correlated instruments could provide some interesting trading opportunities. That is why it’s worth looking at other markets while trading currencies, not only to estimate their value, but also to see if an interesting trade could be opened.
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