You may think that the $5-trillion-a-day forex market may be too big to get caught up in the movements of other, smaller asset classes, but that's not the case. The forex market doesn't move in isolation — what other asset classes do can have big implications for currency prices. Here's how:
Equity markets: If an equity market is rallying, check the domestic currency — sometimes it can follow suit. The Bank for International Settlements (BIS) believes that there is a link between forex and equities. In its view, forex trading can be driven by equity investors who go overseas to get better returns. Investors need to trade forex for two reasons:
To buy foreign assets
To hedge their returns
Between June 2013 and May 2014, a puzzling thing happened: The Eurozone economy was underperforming many other global economies, but the euro was rallying. Instead of being driven by fundamentals, the single currency was moving in line with the Euro Stoxx equity index, which rallied nearly 10 percent over that period.
Commodities: This is one of the most talked about correlations because the vast majority of commodities are priced in U.S. dollars. So, when the U.S. dollar rallies, the prices of commodities can fall because you need fewer dollars to buy your commodity. The reverse is also true if the dollar falls in value. If you see a sudden change in the dollar's value, take a look at what gold and oil prices are doing.
The commodity/forex correlation doesn't not end there. Some commodity currencies can also move with commodity prices. For example, Canada is the world's sixth-largest oil producer, so if the price of oil is rising, this can be good news for Canada's economic fundamentals, which can also be good news for the Canadian dollar, and vice versa if the oil price is falling.
Bond yields: An economy that offers higher returns on its bonds can be an attractive place to buy currency for obvious reasons. So, countries with higher bond yields can see their currencies rise relative to countries with lower bond yields. But beware: Sometimes high bond yields can spell disaster. For example, during the financial crisis in 2008, Iceland's two-year bond yields surged to 13 percent, but the government had to pay that much to attract funds because the economy was on its knees. It required a bailout, and the Icelandic krona fell more than 100 percent between 2007 and 2010.
USD/JPY and the Nikkei: This is a popular cross-asset correlation, but it may not move as you expect. Because the yen is considered a safe haven, investors tend to buy it during periods of market distress. When the Nikkei is falling, the yen can rise, which weighs on USD/JPY. The opposite can also be true, so when the yen is falling (USD/JPY rising), the Nikkei can be on a march higher.
Multiple factors can drive forex markets. Correlations with other markets are just one factor, but they can be very effective. When you trade forex, keep in mind that currencies don't trade in isolation.