Asset correlation refers to the price of two or more assets moving together. The markets can correlate in a positive way (both assets prices go up) or negative way (both prices go lower).
It is crucial to understand the reasons leading to specific asset correlations. Identifying them can help you track down price movements and market trends. Ultimately, the more you know about this topic, the more you’ll be able to improve your trading expertise and know-how.
Intermarket analysis – a case study for asset correlation
The Intermarket analysis examines the different correlations between different groups of assets and not just individual associations.
For instance, when looking at the U.S. financial market, you'd want to study bonds and commodities, not just the U.S. Dollar. Any significant changes in those two related markets (commodities and bonds) may impact the American currency. As a direct correlation, the stock market could also potentially feel the impact because it’s linked to the strength of the currency.
Another frequently mentioned correlation is the inverse relationship between stock prices and interest rates. According to market theory, whenever interest rates increase, stock prices fall, and vice versa.
Conclusively, traders consider the Intermarket analysis part fundamental and part technical analysis because it borrows notions from both. There are different approaches to Intermarket analysis, some of which are more complex than others, but this will be a topic for another post in our featured articles section.
Cross-asset correlations – definition and critical concepts
A smaller segment of Intermarket analysis, the cross-asset correlation explores the relationships between instruments from different asset classes. Following the profound global crisis of 2008, the markets regrouped, making room for denser cross-asset associations. Currencies, commodities, bonds, and stocks experience the highest degrees of inter-connectivity.
Intense volatility strengthens the correlation effects
When the market outlook shifts unexpectedly, assets generally feel the shockwaves down to their core, forcing them to readjust. During those moments of high volatility (such as the current Covid-19 pandemic effects to the global economy), entire sectors feel the impact. The consequence? Investors tend to change their strategies and trading approaches.
Usually, they resort to selling stocks, soft commodities (grains, coffee, sugar), energies (oil, natural gas), and corporate bonds. All these assets present an enhanced risk under such circumstances, according to market analysts.
As a direct result, the price of all the assets mentioned above moves in sync, forcing a tighter relationship between instruments belonging to more than one asset class.
Well-known asset correlations
Forex and the stock market
The currency market and stocks share a strong cross-asset correlation. They’re both affected by interest rates and inflation, plus many other economic factors. But, according to market analysts at fxstreet.com, exports are also one of the main reasons for their inter-connectivity. More prominent companies rely on exports to expand their businesses, and in turn, these exports rely on currency value. So, when the Forex market is bearish, exports become cheaper, and companies can grow and boost their earnings. When currencies are up, exporting becomes more expensive, companies sell less, and their market value decreases.
Examples of cross-asset ties between currency markets and equities:
- the USD/JPY pair and U.S. stock market
- the CHF and various equity markets (particularly the U.S.), and many others.
Commodities and currencies
Most of the world's commodities are priced in U.S. dollars. This means any changes in the USD can impact commodity prices and especially gold and oil. The latter are historically connected with the American currency.
Typically, a strong Dollar makes commodity values go lower, and a weaker USD makes commodities more valuable.
Some countries depend on commodities for their exports (like the Gulf-area nations). So, when commodity prices are affected by various factors, their respective economies feel the impact.
For instance, if a country exports much oil, its economy will be impacted by events leading to oil price changes. Examples are the OPEC meetings, U.S. vs. Iran conflict, and others.
Examples of cross-asset ties between commodities and currency markets:
- gold and the AUD (Australia is famous for its gold exporting industry)
- CAD/USD pair and oil (Canada exports 3 million+ oil and petroleum products/day to the US.).
Currencies and bonds
Why should forex investors be interested in the bond market? The answer lies in both currencies' and bonds' ties to interest rates.
This is how everything is related:
- Bonds and currencies move with interest rates.
- Whenever interest rates are forecasted to rise, yields and currencies are expected to climb as well.
- Economies with higher bond yields attract more investors, creating demand for the local currency; the opposite is also correct.
In this article, we showed you how asset correlation works and how you can interpret it to decipher the financial market's web of connections. Understanding how everything is glued together can give you a unique edge for your trading strategies and objectives.
If you practice and persevere, you will unravel more things about this complex topic, which is crucial for the capital markets and the world of investing.
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Sources: babypips.com, investopedia.com, fxstreet.com
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