Just as there are many intra-market correlations between currency pairs, so too there are many intermarket correlations between the Forex and other financial market, such as stocks, bonds and commodities. Traders who develop an understanding of these correlations, along with their important fundamental and psychological relationships, can use them to their advantage, creating strategies that in-bed these relationships.
In this article, we will seek to cover the three most powerful of the intermarket correlations:
- US Dollar Index and Currencies
- Global Stock Indexes and Currencies
- Gold and Currencies
1. US Dollar Index and Currencies.
The US Dollar Index The US Dollar Index (USDX) is a futures contract listed on the New York Board of Trade (NJBOT) and Dublin-based Financial Instruments Exchange (FINEX) futures exchanges. The U.S. Dollar Index provides the world with a comprehensive barometer of the value of the U.S. Dollar. Just as the Dow Jones Industrial Average provides a general indication of the value of the U.S. stock market, the U.S. Dollar Index provides a general indication of the international value of the U.S. Dollar. The USDX does this by averaging the exchange rates between the U.S. Dollar and six major world currencies: EUR, JPY, GBP, CAD, CHF and SEK.
The exact weighting of the other currencies in the U.S dollar index are:
As you can see, there is a strong European bias to is index, as the Eurozone, United Kingdom, Sweden, and Switzerzland total 77.3 percent of the index. Standing on top is the Euro, which comprises 57.6%, due no doubt because the EU is the United State’s super power equivalent. This European bias is fine for today, as these economies do represent some of the largest in the world, but in the future, if geopolitical relationships were to change, that 57.6% (or any other weighting) becomes more problematic. If some of the countries within the Eurozone go totally bankrupt and must depart from the EU and the Euro, the index may need to be re-calibrated. If other large economic powerhouses like China decide one day to de-peg the Yuan from the U.S.Dollar, then the index would need some rebalancing to include the Yuan.
The reason why one should look to this index for a gauge of dollar strength, and not to a single currency pair, such as the USDCAD, is that the effects of bi-national issues on currency prices are minimized by the other currencies in the basket. The United States is almost always in some sort of trade dispute with EU, Japan, China, England, or even Canada, and trade relationships are intricate and new regulations, national or international, can have dramatic effects on currency values. Though there are less trade disputes with the neutral Switzerland, we have seen how its central bank can intervene directly in the market to make sure that their currency does not become so strong as to negatively impact their export sector. Any one country can have their own economic issues and currency fluctuations, but when weighted into the USDX, these fluctuations are smoothed out.
Here is a 6 month comparison of the US Dollar Index with EURUSD taken on Jan 30, 2012:
Tip: You can go to bloomberg and type in any currency pair in the [?] Add a Comparison box to see the degree of visual correlation.
Notice the mirror-like pattern between the US dollar index and the EURUSD. When the US dollar strengthens, the EURUSD falls, and vice versa. You will see more of this mirror-like pattern between the US dollar index and the EURUSD than between any other currency pairs because of the heavy euro weighting in the index.
What can be done with the strong correlation between the US Dollar Index and other currency pairs one is trading?
Strategy #1: Clearer Picture of US Dollar Movement
When the outlook for the U.S.Dollar seems uncertain, one can look to the U.S Dollar index as a clearer picture of the situation. If the US dollar is not at the moment trending, the index will often will be testing key support and resistance levels, and when these levels are broken many traders will react to the breakout from these levels, piling into the new trend. Sure, powerful moves by certain spot currency pairs may direct the direction index, but at the same time, it can be seen that the index itself is provoking change in the U.S. dollar pairs.
Strategy #2: Leading Indicator on Trends and Trend Reversals
The dollar is certainly the main driver in the currency market, the center of the earth through which all the currencies rotate around. USD index is an indicator to see opportunities, since almost all pairs are correlated with of usd. If usd index is trending weaker, we can feel more confident in buying EURUSD or selling USDCHF, and if it is trending stronger, we can feel more confident in selling EURUSD or buying USDCHF. Sometimes, because the USD index is a leading driver of the currency markets, it can provide a faster trend reversal signal on the majors than watching any one of the majors themselves. It behooves any serious trader to keep on eye on it.
Sources for US Dollar Index:
Finance Websites that provide free charting:
MT4 Brokers that provide USDX or US Dollar in market watch:
AVA Trader (AVA Broker)
MT4 Indicators that plot US dollar as sub chart:
2. Global Stock Indexes and Currencies
If any of us have any knowledge of finance prior to trading currencies, it is probably in the realm of trading stocks or the stock indexes. Though there is 100 times more money traded on forex than the US stock markets, there is no doubt more people looking at or trading the US stock markets than the currency markets. It has only been the last 10 years that retail traders have jumped upon the currency markets, whereas retail traders and investors have been trading US stocks since the 19th century. Every major financial cable network or radio show has to cover the movements of the Dow Jones every day, and the currency markets only get brief coverage, if at all. Everyone knows something about stocks, whereas few know anything about forex.
This greater popularity of the stock markets carries with its own advantages. As I have noted in my technical analysis section, many technical indicators or chart patterns are more powerful when more popular. Popularity lends to them a self-fulfilling power. For instance, there might not be any magical reason why the 200 day moving average has any more significance than any other length and time frame other than the fact that most people are told that it is the length and time frame to watch out for, and when it is crossed on the upside, this is the “golden cross” for a strong bullish market. The same holds true for markets. The more popular the market, the more any indicator works better for it. Thus, by extension, if more people are looking at one popular indicator on one popular market, like the Dow Jones, then it is going to have more significance than the same indicator on a less popular market. With many more eyes trying to dicipher the movement of the US stock markets, then any new trend discovered on it can act as a early warning on any strongly correlated currency pair.
Here is a comparison of the Dow Jones with EURUSD, GBPUSD, AUDUSD from Jan 2010 to Jan 2012:
Notice how the three currency pairs move in similar directions with DJ, though in different amplitudes. In the last two years it is clearly seen that the AUDUSD has maintained the closest correlation to the DJ, whereas EURUSD and GBPUSD did not rise as much in the last two years, due no doubt to the European sovereign debt crisis. When I conducted a google search on the relationship between the DJ and AUDUSD, I quickly found that David Rodriguez of DailyFX spots a similar relationship in his article, Correlations: Australian Dollar Trades as Alternative to Dow Jones.
If you find currency pairs like the AUDUSD that are more correlated to the DJ or other financial indexes, what can be done with these correlations?
Strategy #1: Leading Indicator on Trends and Trend Reversals
There are probably more people looking at the moving averages and trend lines on Dow Jones than on any one currency pair. This means that when these lines are drawn, they stand up as more accurate and reliable because of their greater degree of popularity and by extension, self-fulfilling prophecy. When the Dow Jones breaks up through the famous 200 day moving average, it signals to all stock traders that the stock markets are bullish, and to all currency traders that any DJ correlated pairs like AUDUSD are also likely to be bullish. Similarily, when support and resistance lines are drawn on the Dow Jones, and there is a strong break up or down through these lines, one can expect a strong move in the DJ that is closely followed by a strong move in DJ correlated currency pairs.
Tip: I have been mentioning the DJ correlation as only one possible correlation. There are many more global financial indexes than the DJ that may prove to have more reliable relationships and act as an faster leading indicator. I advise you to look at all the global indexes in relationship to all the major and minor currency pairs.
Sources of Global Indexes
Finance Websites that Provide Free Charting:
MT4 Brokers that provide stock indexes:
3. Gold and Currencies
The origins of correlations between gold and forex are many. Gold is seen as an alternative to currency. It is seen as a safe haven in times of uncertainty. Some central banks are adding to their gold reserves. It benefits from near-zero interest rate levels. Lastly, it is viewed as an inflation hedge.
The US Dollar was once backed entirely by gold, thus earning the term “greenback” but by the 1970s, during an inflationary cycle, Nixon axed the connection to gold, and since then the dollar has been in a steady fall. The Swiss Franc (CHF) was once 40% backed by gold and silver, but has abandoned this “backing” when the Swiss had to sell much of its gold and silver reserves to join the IMF by 2006. Today not a single currency is backed by gold or silver, as all nations have inflated their currencies to unprecedented levels in the last 50 years. Most countries do own gold but their gold reserves are not explicitly owned for the purposes of backing their currencies.
At different times in the last 20 years, gold has enjoyed a strong correlation to some currency pairs, particularly currency pairs known as commodity pairs (AUDUSD, NZDUSD and USDCAD). While CAD is correlated with oil, it’s correlation is not that strong as compared to AUD, NZD and CHF with gold. AUD has the strongest tie to gold, not because it has the largest gold reserves, but because it is one of largest gold producers. Australia remains a major producer of gold, the fourth-largest producer in the world, coming in behind China, South Africa, and United states, and as a result, it is only natural that AUDUSD follows a similar pattern to gold. The currency has moved in lockstep to the commodity until mid-2008. Since mid-2008, the correlation has weakened somewhat, with gold on a bullish run in a much greater degree than AUDUSD.
Here is a comparison of XAUUSD (Gold) and AUDUSD over the last 5 years, from Feb 2007 to Feb 2012:
From 2007 till 2012, AUDUSD moved in the same directions as gold but in different amplitudes. AUDUSD fell much harder than XAUUSD in the financial crisis of 2008, and it recovered from the fall 2 years later in Sept 2010 whereas Gold had recovered in Feb, 2009. XAUUSD had gained an extraordinary180% in the last five years, whereas AUDUSD has gained handsome 40%.
I would also argue that Gold and USD are negatively correlated. Gold is known as Antidollar. When USD rises, gold prices fall and when USD falls, gold prices rise. I would not necessarily argue that Gold and the USD dollar index are negatively correlated, because the U.S. dollar index has such a strong euro weighting; instead, I would argue that usd quoted pairs, like USDCHF and USDJPY are negatively correlated with Gold.
Here is a comparison of XAUUSD (Gold) plotted against USDCHF and USDCHF over the last five years, from Feb 2007 to Feb 2012:
Notice how when gold had been gaining extraordinary strength in the last five years, so too have been the Franc and Yen, as reflected in the steady fall of USDCHF and USDJPY. The Franc has gained 25% and the Yen has gained 35%, almost as much as the Aussie’s 40% without the same amount of volatility. Why this correlation? Because when gold gains strength, it is doing so against the U.S.dollar. Similarly, when the U.S dollar is weakening, the USDCHF and USDJPY are descending down (weaker dollar / stronger CHF or JPY). But the Swiss franc retains a secret correlation with gold.
USDCHF and Gold. For close to 80 years, the Swiss franc has been considered a safe-haven with virtual zero inflation because of its legal requirement to have 40% be backed by gold reserves. However, its 80 year link to gold was terminated on May 1, 2000 following a referendum. By March 2005, following a gold selling program to join the IMF, the Swiss National Bank holds 1,290 tonnes of gold reserves (20% of assets, half as much as before). Nevertheless, the anonymity and neutrality of Switzerland make the Swiss Franc a safehaven during turbulent times. The USDCHF performs to parity with gold prices, with the dollar representing an “anti-gold” wager and the Swiss Franc being a partial gold hedge. More recently, since the Global Financial Crisis (2007-2012) and concurrent Sovereign Debt Crisis (2008-2012), investors have been turning to the Swiss Franc as an attractive European alternative. It is a partially gold-backed currency and it is also one of the few currencies in Europe that isn’t the Euro.
Can these strong correlations between gold and AUDUSD or USDCHF be used to profitably trade these pairs? The answer is YES.
Strategy #1: Leading Indicator on Trends and Trend Reversals
There may be times when it is hard to know what future direction pairs like USDCHF and AUDUSD are going to take. They may be currently stuck in a range or sideways market and you don’t have any clue as to when and in what direction a trend might development. This might be the moment to consult a leading indicator like the Gold chart. Here you pull out the daily gold chart and apply to it a 200 period moving average to see if it is above it (for an uptrend) or below it (for a downtrend). Then, if you detect that gold is trending, you can can find a way to jump into long AUDUSD or short USDCHF on retracements in price.
The gold correlated pairs may even prove to be leading market indicators on gold. Sometimes it is hard to determine which is going to be the leading market indicator (which is going to lead which) — gold or the aforementioned gold-correlated currencies. Sometimes you just need to experiment and backtest different indicator based strategies for entries/exits transplanted from a gold chart to AUDUSD or USDCHF charts, and then alternately, entries/exits transplanted from AUDUSD or USDCHF charts to a gold chart. You may be surprised to learn that there is a currency pair that acts as a powerful leading market indicator for deciding the direction of gold. In that case, you may try trading gold as a CFD in many non-US forex brokers.
Sources for Gold or XAUUSD:
Finance Websites that provide free charting:
MT4 Brokers that provide Gold (XAUUSD) and Silver (XAGUSD):
|Broker||MinLot||XAG Spread||XAU Spread|
|Price Market Dynamic||0.01||24.8||17.4|
|Boston Prime Pro||0.01||5.95||27.3|
|Vantage FX Standard||0.01||9.0||34.0|
|Gallant Capital Markets Pro||0.01||13.68||66.1|
|FX Pig ECN||0.01||12.76||74.9|
|Talinex ECN Pro||0.01||20.8||153.6|