The Forex market moves based on multiple correlations. Risk-on and risk-off events define the way a currency pair travels. Because the U.S. dollar is the world’s reserve currency, the dollar pairs, or the major pairs, move in a correlated fashion. If one buys the AUDUSD pair because of a dollar driven event, an equivalent trade would be a long in the EURUSD pair.
Correlations are everywhere in the trading arena. Even though one trades only the Forex market, other factors may influence the currency pair he/she trades. Indices trading is strongly dependent on the way the JPY pairs move, or the other way around: the JPY pairs depend on how indices move.
The strongest correlations are found between the USDJPY pair and the DJIA index. It is a direct correlation and it used to be stronger in the past than it is now. A few years back, the USDPY and the DJIA (Dow Jones Industrial Average) correlation was almost a hundred percent. For every USDJPY pip higher or lower, the DJIA followed suit.
It is not that strong anymore, but the correlation still holds true. It is a result of the indirect relationship between the interest rate differential between the two currencies and the implications the interest rate has on the equity market.
As a rule of thumb, higher interest rates lead to lower equity prices. The opposite is true as well. However, it doesn’t mean that always the index will fall when the interest rates in the United States rise.
Let me give you an example. Assuming the interest rates in the United States will rise, is it mandatory for the DJIA index to fall, as the correlation implies? Not necessarily. It could be that the financial stocks (banking sector) rise more than the other DJIA components, and this will put a floor on the DJIA fall.
Above are the one-on-one daily DJIA and USDJPY chart. The correlation degree between the two is obvious. The bullish trend started with the U.S. Presidential election result when Trump was elected the 45th President of the United States. The same break higher came on the USDJPY pair, almost similar.
Before the U.S. elections, the DJIA index was in a four-month consolidation range. No matter the economic news released, nothing could make the index breaking either higher or lower. That is until the U.S election result was known. While ahead of the vote, the market reacted negatively to any positive news regarding Donald Trump, when the actual result came in, it was aggressively bought.
The same reaction can be seen in the USDJPY pair. On the chart above, the red candles represent the USDJPY pair and there are overlapping the DJIA index. While it is lagging a bit, in the end, the two financial instruments correlate in an impressive manner.
It is not the same with other currency pairs. Except for the EURUSD and the USDCHF that are now strongly correlated because of the EURCHF inability to move, other currency pairs do not trade in the same manner. Not event the risk-off/risk-on relationship is not that strong like it used to be.
The other JPY pairs follow the USDJPY one. Because the U.S. dollar is the world’s reserve currency, this major is the one that sets the tone for the other JPY pairs too. Therefore, the USDJPY correlation with the DJIA index is the one that matters both for the currency market and for global equities too.
Moreover, when the DJIA in the United States is having a bad day, not only that the USDJPY follows in the same direction, but the world markets make the same move. In this way, one can tell that the real driver for the world’s equity markets is the state of the U.S. equity, and this is seen in the way the USDJPY pair moves.