Understanding the Relationship of the Stock Market with the Forex Market
Reading time: 20 minutes
The stock market and the forex market are two of the world's most widely followed and traded financial markets. But have you ever stopped to consider how these two markets are related?
In this article, we’ll explore the intricate and complex relationship between the stock market and the forex market. We will delve into the similarities and differences between the two markets and examine how changes in one market can impact the other.
Introduction to Forex
Forex, or foreign exchange, is the largest financial market in the world, with approximately $7.5 trillion in daily volume, according to the Bank of International Settlements. It’s where the world’s currencies are exchanged and traded, operating 24 hours a day, five days a week. The foreign exchange market is decentralised, meaning it has no central trading location. Instead, it’s formed by a global network of banks, corporations, and individual forex traders.
The history of forex markets can be traced back to ancient times when traders exchanged currencies like gold and silver. However, it wasn’t until the 1970s, when the Bretton Woods system collapsed, that the modern forex market as we know it today was born. The system had pegged the US dollar to gold, and many developed nations pegged their currency to the dollar. After its downfall, many currencies were no longer tied to a fixed exchange rate, leading to the widespread adoption of floating exchange rates. As a result, the exchange rate of most currency pairs is now determined by supply and demand.
Forex trading involves buying and selling currency pairs with the aim of making a profit from the fluctuations in exchange rates. The most commonly traded currency pairs are EUR/USD, USD/JPY, and GBP/USD (Major currency pairs). Forex brokers facilitate the trading of currency pairs and can provide traders with access to the interbank market.
Introduction to Stocks
Stocks, or shares, are units of ownership of a company that are traded on a stock exchange. They represent a portion of the company’s assets and earnings, and their value is determined by supply and demand. Stocks can offer investors dividends - a share of the company’s revenues - and profits through price appreciation.
The stock market began in the 17th century when the Amsterdam Stock Exchange was established. Since then, it’s grown significantly, with many countries having their own stock exchanges. The New York Stock Exchange (NYSE) and the Nasdaq Stock Market are the two largest exchanges in the US.
Stock trading involves buying and selling stocks in the hopes of turning a profit, either in the short term or over many years (capital appreciation). The value of a stock is influenced by several factors, including the company’s financial performance, industry trends, and overall market sentiment. Like forex trading, stock traders typically use a broker to buy and sell stocks.
Differences Between Forex and Stocks
One of the most notable differences between forex and stocks is their trading hours. Forex trading operates 24/5. Meanwhile, the stock market operates during specific hours, depending on the individual stock exchange. The NYSE is open from 9:30 a.m. to 4:00 p.m. EST, while the Tokyo Stock Exchange is open from 9:00 a.m. until 3:00 p.m. JST.
Volume and liquidity can also vary significantly between the forex and stock markets. The two largest currencies, the US dollar and the euro, combine to create EUR/USD. This pair is highly liquid (meaning traders can easily get orders filled with minimal slippage) and saw an average daily volume of $925 billion in London alone in 2022 (Bank of England).
On the other hand, the stock market is relatively smaller, and liquidity depends on the stock. Even titans like Apple and Microsoft, the two largest US stocks by market cap, see much smaller daily trading volumes than major currency pairs.
Additionally, forex trading generally allows for much higher leverage than stocks. In the US, stocks are generally limited to up to 4:1 leverage for retail investors, while forex leverage is much higher.
Given the frequent economic releases that can cause significant price fluctuations, the forex market tends to see more volatility. Combined with leverage, this can make forex trading riskier than stock trading. However, it also means there can be more intraday opportunities when trading currency pairs compared to stocks.
Similarities Between the Forex and Stock Markets
There are some evident similarities between these two financial markets. The first is that both markets are affected by economic indicators, such as interest rates, inflation, and gross domestic product (GDP). These indicators can provide insights into the health of an economy and affect the supply and demand for stocks and currencies.
Central banks can also indirectly influence a currency or stock’s price through monetary policy. Raising interest rates, in theory, makes a currency more valuable while decreasing demand for stocks. Likewise, adverse political events can make investing in or trading with a country less attractive, which tends to harm both currencies and stocks.
Market sentiment and psychology play a key role in both markets, partly as a consequence of economic releases and central bank/government actions. When the conditions are favourable, sentiment can turn bullish and increase demand for a currency or stock, and vice versa.
When Do Forex and Stock Trading Work Best?
Trading activity in the forex market tends to pick up at the start of the London, New York, and Tokyo sessions, providing the volatility necessary to create trading opportunities. The overlap between London and New York is the busiest. Meanwhile, stock trading activity generally peaks during the opening hours of a stock exchange and tapers off throughout the day until an hour or so ahead of the close.
Market conditions can also determine when forex and stock trading work best. The forex market is more volatile during important news releases or economic events, creating opportunities for traders. Similarly, the stock market tends to be more volatile during earnings seasons or significant news events related to individual companies.
Examining the Relationship Between Stocks and Currency Rates
In theory, a growing stock market signals that an economy is expanding, leading to increased demand for a currency from foreign investors. These investors would need to exchange their native currency for the currency of the country they’re investing in to purchase stocks and other assets.
Before the 2008 financial crisis, this relationship was seen in Japan’s Nikkei 225 and USD/JPY. When the Nikkei rose, traders would short USD/JPY, believing the Japanese yen would increase relative to the US dollar. However, following the crash, many considered the yen a safe haven asset, pushing USD/JPY lower while the Nikkei fell in tandem.
A weaker currency can also be favourable for a stock market. When a country’s currency is weak, it costs less for foreign importers to buy goods from that country. For economies that rely heavily on trade, this can drive up the profits of their exporting companies and boost the stock market. When the currency gets stronger, the price of an economy’s exports rises, resulting in lower profits for multinational companies.
Defining Nikkei 225 and Its Brief History
The Nikkei 225 stock index tracks the performance of the top 225 blue-chip companies listed on the Tokyo Stock Exchange. The index is considered the benchmark index for the Japanese stock market and is widely regarded as one of Asia's most important equity markets. It’s the Japanese equivalent of its US counterpart, the Dow Jones Industrial Average (DJIA).
The Nikkei 225 was first introduced in 1950. It’s calculated by the Nihon Kezai Shimbun newspaper, commonly known as Nikkei. In contrast to most stock indices, which are market cap-weighted, the Nikkei is price-weighted, meaning that stocks with the highest share price have the greatest impact on the index’s overall performance.
While most other stock indices tend to grow exponentially over the decades, the Nikkei has been an outlier. Thanks to the Japanese government's loose monetary and fiscal policy in the 1980s, Japan went through a massive asset bubble, bursting in 1989. This led it to fall over -82% between 1989 and 2008. While it has recovered since, the Nikkei is still down approximately -30% from its all-time high today.
Defining Dow Jones Industrial Average and Its Brief History
The Dow Jones Industrial Average (DJIA), also called the Dow, is a stock market index that tracks the performance of 30 large blue-chip companies listed on the NYSE and the Nasdaq stock market. The Dow is one of the world's most significant and widely recognised indexes and is often used as a barometer for the overall health of the US economy.
At its launch in 1896, the Dow included just 12 companies in the industrials sector. Given that the growth of the overall economy was heavily linked to the development of industrials in the early 20th century, the performance of the Dow was watched by investors to determine the state of the US economy.
In 1928, the Dow expanded to include 30 companies. Nowadays, it’s made up of select companies across a wide range of sectors, like healthcare, technology, and consumer goods, and features companies like Microsoft and Home Depot. Like the Nikkei, the Dow is price-weighted.
While the Nikkei has suffered from a turbulent past, the DJIA has performed exceptionally well. Between 1982 and 2021, the Dow grew almost 4,700%, from around $770 to a high of nearly $37,000.
The Relationship Between Nikkei and Dow
Given that both stock indexes are seen as most representative of their respective economies and that Japan and the US trade heavily together, it’s no surprise that the Nikkei and Dow are correlated. While the correlation isn’t perfect, it’s typical for a good day in the Japanese stock market to result in gains for the American stock market.
While many factors are at play here, one of the most significant is the interdependence between Japan and America. Japan is the US’s fourth-largest trading partner, while the US is Japan’s second. Raw materials, like chemicals, and capital goods, like machinery and transportation equipment, are frequently traded between the two countries.
As a result, negative economic news in Japan could lead investors to believe it’ll import less from the US, causing the Dow to fall and vice versa. Japan is particularly dependent on oil from the US, and while none of the Dow’s components produces oil, decreased demand for US oil has a knock-on effect on the rest of the economy.
Tips on How to Trade Forex Better When the Stock Market Is Down
Unfortunately, there’s no clear-cut way to determine where a currency may move when its stock market is tumbling. As discussed, a strengthening currency can indicate that investors are positive about a country’s growth, but it can also reduce the competitiveness of companies abroad. It all depends on the individual economy, its macroeconomic makeup, and the components of its stock market.
That said, there is a way to better understand where a currency might be headed. We can analyse the correlation between the stock market and the currency. The chart above shows DXY, the US dollar index, plotted alongside the S&P 500 e-mini futures. The bottom window (correlation coefficient) indicates that the relationship between the two has been largely negative, at least since late 2021.
We can say that, on average, a falling stock market will likely mean the dollar becomes stronger. When paired with other analyses, like the dovish Bank of Japan (BoJ) keeping interest rates low and weakening the yen, we can hypothesise that USD/JPY will likely rise when the S&P 500 falls.
While the picture isn’t as straightforward as the DXY-S&P 500 relationship, we can see, since May 2022, the correlation has been mostly negative between the S&P 500 and USD/JPY. We might then start with an assumption that USD/JPY will rise as the S&P 500 falls, then use other technical and fundamental analysis to confirm our bias and determine our trading strategy.
In summary, the forex and stock market share strong similarities, but there are plenty of key differences to be aware of. The two are inextricably linked, with changes in one market often impacting the other. It’s also worth understanding the correlations between two separate stock markets, like the Nikkei 225 and the Dow Jones Industrial Average.
While trading correlations between the stock and forex markets is never simple, learning how the two interact may help you identify potential opportunities and manage risk more effectively.