Understanding the Correlation Between Stocks and Currencies

You must have heard people talking about stocks and indices in your FX chat room or at any other Forex forum that you joined to gain insight about the Foreign Exchange world. If you are new to Forex then you start thinking that why are they so interested in stocks and indices even though they are not trading them? Why are they paying attention to and why is it important to understand the correlation between stocks and currencies? You probably feel awkward at that point because you have no idea what to say and how to participate in such an ongoing conversation. So let’s find out how stocks and foreign exchange are correlated with each other and what is this relationship between stocks and currencies.

Relationship between stocks and currencies

Before understanding the relationship between stocks and Forex you need to know which stocks are frequently talked about and what makes them so special. So here is the list of some of the famous stock indexes that you get to hear about.

DOW JONES:

The Dow Jones Industrial Average or Dow for short is one of the most notable and premier indexes traded in US. It comprises of 30 most powerful companies operating in the country. This index is widely used to determine the industrial performance of the US economy. Its performance is also influenced by external factors like natural catastrophes, war or any political events etc that could bring any sort of change or harm to the economy. Catching the attention of investors from all around the globe this stock index has become a sort of market sentiment indicator predicting the future of US dollar.

 The S &P 500 or Standard and Poor’s 500:

Considered as the best to gauge the US stock market and US economy, it is the most commonly followed indices after the Dow Jones. The Standard & Poor’s 500 or simply S&P 500 includes 500 large American companies and captures approximately 80% of the available market capitalization.

NASDAQ:

It’s a global electronic exchange market where securities are being traded. It stands for National Association of Securities Dealers Automated Quotations. It is the place where most technology stocks are traded. There is a lot of trading activity here and hence it becomes a good indicator of gauging the performance of technology and growth companies. NASDAQ composite is an index that includes more than 3000 companies which are tech giants like Google, Apple, and Microsoft etc listed on the NASDAQ exchange.

DAX

DAX is a German stock index that comprises of 30 blue chip German companies trading on the Frankfurt Stock Exchange. Germany plays a great part in the Euro zone economy so this index is being watched by the investors so as to get any indication about the upcoming growth or market turmoil in Euro zone.

EURO STOXX 50

Comprising of 50 largest and the most liquid stocks, The EURO STOXX 50 is a stock index of Euro zone stocks. It is also in the watch list of all the investors out there. By representing the stocks of the 50 major blue chip companies, it is considered to mirror the overall performance of Euro zone stock market.

NIKKEI:

Nikkei is a price weighted index of 225 companies in Japan which includes Toyota, Sony, and Honda etc and is currently the most widely quoted average of the Japan Stock Market. Due to this attribute Nikkei seems to give the most possible reflection of the overall Japanese market.

FTSE 100

FTSE 100 index or simply called “footsie” is listed on London stock exchange and is a share index of 100 companies which have the highest market capitalization. Again this index is used as an indicator to determine the possible performance of the UK economy

Correlation between stocks and currencies

Now lets us discuss how these stocks affect the Forex market and currencies. If you see a rally in the stock market of US with Dow Jones, S&P 500 or NASDAQ rallying and gaining new highs, the foreign investors will likely to put their money in the stocks of this country because they also want to enjoy the fruits that this market is currently giving. In order to do so they will have to buy US dollars first to buy the stocks, which means they will sell their domestic currency in order to buy the US dollar which will cause the US dollar to rise. Similarly the country which faces a downfall in the stocks market will see their currency going down because now the foreign investors are drawing their money out and selling off the stocks and reconverting the US dollars into their domestic currency or some other form of investment.

Now if you know that this country’s stocks are going up then you can buy that currency because that currency is getting stronger now and will rise. Similarly a country whose stock market is facing a decline you can sell that country’s currency because now that currency is getting weaker and will likely fall down.

Relationship between stocks and Forex is not this simple. Their correlation may change from time to time depending on the global financial condition. Like way before financial crises of 2007 Nikkei and USDJPY were inversely correlated but soon after that they become positively correlated. So you better not depend on just correlations. Fundamentals and technical’s are way more important.

Nikkei and USDJPY have shown a strong correlation. Sometimes they are uncorrelated but that is only for a short period of time then they get together again. So any news that can affect Nikkei will possibly affect USDJPY too so keeping an eye on it will help you in getting an opportunity to go long or short..Below is a chart showing correlation between USDJPY and Nikkei.

I hope you found this article quite helpful and now correlation between stocks and currencies is not a hard nut to crack. 🙂

Any questions or comments in this regard are highly appreciated.