One issue with using global equity markets to make forex trading decisions is figuring out which leads which.
It’s like answering that age-old question, “Which came first, the chicken or the egg?” or “Who’s yo daddy?!”
Are the equity markets calling the shots? Or is it the forex market that wears the pants in the relationship?
The basic theory is that, when a domestic equity market rises, confidence in that specific country grows as well, leading to an inflow of funds from foreign investors.
This tends to create a demand for the domestic currency, causing it to rally versus other foreign currencies.
On the flip side, when a domestic equity market performs terribly, confidence falters, causing investors to convert their invested funds back into their own local currencies.
Sounds great in theory, but in reality, it’s…complicated.
For example, the historical relationship between the U.S. dollar and the S&P 500 hasn’t been consistent.
As shown below, over the last 20 years they have moved together, moved in opposite directions, and have been unrelated.
But that doesn’t mean the relationship is useless. You just have to know when the correlation is working (whether negative or positive) and when it’s not.
Here’s an example where for U.S. and Japan stocks moved in opposite directions of their currencies.
Any upbeat economic figures in the U.S. and Japan more often than not weigh down on their respective currencies, the dollar and yen.
First, let’s take a look at the correlation between the Dow Jones Industrial Average and the Nikkei to see how stock markets all over the globe perform relative to each other.
Since the turn of the century, the Dow Jones Industrial Average and the Nikkei 225, the Japanese stock index, have been moving together like lovers on Valentine’s Day, falling and rising at the same time.
Also notice that sometimes one index leads, rallying or dropping first before being followed by the other index.
It doesn’t happen every single time, but you could say that stock markets in the world generally move in the same direction.