The Relationship Between Forex and Stocks: How Does One Affect The Other?
If you are into trading, chances are that you either deal with stocks or forex. There are other types of markets available for investors, but the above two are arguably the most common ones, and for a good reason. A deeper understanding of the two markets is important before understanding how they overlap each other.
What are stocks
A stock is a unit of ownership in a publicly listed company. There has to be a regulated market on which they are listed, such as the NASDAQ or the New York Stock Exchange (NYSE). Thousands of companies in the U.S are listed on the above two exchanges, and they collectively consist of the stock/equities market.
What is forex?
Forex is an aggregate of the words foreign exchange, and it is also commonly known as the FX market. Almost every country has a currency that holds value, and those currencies are brought together into the market where they are traded against each other, thus making the forex market.
Exploring the relationship between forex and equities
The forex and stock market seem distinct from each other from the surface. Their historic performance does not seem to indicate any similarities or correlation. There have been numerous theories that have been presented to explain potential ways in which the two markets affect each other.
The most common theory is that a stock market that performs well tends to attract more investors, leading to capital inflows, especially from foreign investors. The theory also suggests an increase in demand for the local currency. In this scenario, supply and demand laws would be apparent, where the demand for stocks from investors would boost their prices. Triggering more demand for the local currency would thus fuel a bullish performance in the currency.
Unfortunately, the above does not seem to be the case. Stock market indexes paint a good picture of how the overall stock market has performed over a specific duration of time. The Dow Jones Industrial Average in the U.S and the NIKKEI 225 are among the most popular indexes across the world. It thus makes sense to use them to determine whether the forex and stocks market affect each other.
USD/JPY and the NIKKEI 225
The USD/JPY currency pair had an inverse correlation with the NIKKEI 225 prior to the 2008 financial crisis, which means the index would go up when the Japanese Yen was weaker and vice versa. This is contrary to the expectation that the Yen would perform better when the Japanese economy was bullish.
The inverse relationship changed after the financial crisis when the SUD/JPY and the NIKKEI index started to perform in tandem. The NIKKEI index’s performance and the USD/JPY had a positive correlation from around 2007-2008.
The relationship between the Dow and the USD/JPY
There was an inverse correlation between the Dow and the USD/JPY from around 2000 TO 2005, but then things changed, and the correlation turned positive from around 2006. However, it changed again in 2009 to an inverse correlation.
Why the inconsistencies exist
The forex and stock markets are intricate systems that are influenced by a myriad of factors. For example, the stock market might be experiencing a strong bullish performance due to investor confidence fueled by favorable economic policies and fall in case the government makes changes that are not so friendly to taxation policies and such. The forex market is not so different, considering that it is also influenced by similar forces. However, many other factors take place in the background, which would introduce a divergence.
One of the best examples of those differences is a scenario where stock market sentiments might be positive while the sentiments on a specific currency might be negative. A trade war between two countries, such as the one between China and the U.S may cause less of a downside exposure to the stock market than it would cause to the forex market.
External factors such as diplomatic relations have a notable impact on a country’s currency but less of an impact on the country’s stock market. However, there are instances where tensions between two countries might be bad news for forex and the stock market. For instance, a trade war may make it more difficult for companies to sell their products in the feuding country, especially if it contributes a sizable market share, thus causing a dent in profit margins, eventually affecting the stock price.
There are instances where a currency does have a clear impact on the stock market. Companies in a country where a currency is severely affected by inflation might not find it conducive to continue operating in the country. Some may try to survive by trimming their operations just so they can survive, especially in an economy where people can no longer afford much.
Why forex is so important to the stock market
Value is the one thing that brings the two markets together. A stock has a specific value assigned to it at any given point, and the same applies to currencies. If an economic crash has a major impact on a country’s currency, the demand for that currency would be low, which means that it would be bearish as other foreign currencies gain against it. Investors would also jump ship in pursuit of assets that are based on stronger currencies.
Stocks are largely influenced by internal factors that culminate in the company’s financial performance profile. Interest rates and government policies mainly influence currencies. The complex nature of both markets makes it difficult for one market to determine the other’s performance. However, the stock market would not exist without currencies since stocks need to have an attached value.
The impact of the forex market on the stock market is arguably superior to the impact of equities on currencies. However, their performance in relation to each other is inconsistent over time because of the many different factors involved in their operations.