Many traders and analysts have taken advantage of the growing correlation between asset classes to forecast movements in one market by analyzing the changes in another. However, while using the changes in equities to forecast price action in risk-sensitive currency pairs has grown in popularity, the reverse (using FX moves to anticipate changes in the equities market) has not. And, considering the currency market’s deep liquidity and 24-hour session, overlooking such an advantage would be missing out on one of the best strategies in current market conditions.

Why FX is a better leading Indicator for equities

Without a doubt, the top reason for using the currency market as a leading indicator for stocks – instead of the other way around – is the fact that Forex trades 24 hours a day. In comparison, equity traders typically have only six to eight hour sessions. This creates a huge gap of time where an economic release or exogenous event that effects the general appetite for risk can cross the wires without being incorporated into stock prices. The only reprieve for pure equity traders is to anticipate the reaction from a stock market to data or breaking news is to perhaps look at how another country’s benchmark index responded to the data and assume the latter index will follow suit when trading starts. However, many times certain countries’ equity markets will hold off on a response to a macro event until a financial center (like London or the US) comes online and offers its own direction.

A very clear example of the currency market’s ability to lead equities can be seen in the after session hours of November 6th. News that Morgan Stanley would take another $3.7 billion write down from debt-related losses exacerbated an already prolific credit market crisis that had sprung to life only a few months before. The blow the news delivered to risk appetite was immediately priced into USDJPY. However, with the American stock markets offline, equity traders were forced to play catch up when the exchanges opened for trading at 13:30 GMT the next morning. In this situation, watching price action in the Forex market before hand could have prepared a stock trader for the sharp jump in volatility that would develop through the day.

Another reason that Forex is a good leading indicator to the stock market is the depth of liquidity. Typically, traders will use the futures on the benchmark equity indexes as a forecasting tool for price action in the stock market’s active session. This comes with some limitations however as the futures usually have a limited response to event risk and certainly will not give any clues to follow through that could develop after the initial reaction on the open. The currency market, on the other hand, will immediately respond to news or data and show whether the event will warrant a sustained impact. The primary basis for this contrast between the two asset classes is the size of the market (or the depth of liquidity). The Foreign Exchange market clears nearly $3 trillion dollars daily, while even the most active stock index future sees a very small fraction of that activity. What’s more, considering the New York Stock Exchange average daily trading value is only $141 billion, the currency market is better adept at absorbing data more efficiently. Therefore, currencies will react more quickly to data even when the equity market is at full trading capacity.

Why are currencies and equities so closely correlated?

Over the past few years, the correlation between equities and those currency pairs considered top carry trade candidates has tightened remarkably. This distinct connection has developed from greater access to global markets and, more importantly, an intensified appetite for risk. However, where the demand for yield was a commonality that would initially tighten the relationship between these two markets, it has been the flight from risk and demand for liquidity over the past six months that has truly synced the movements between the currency and stock markets on the intraday level. Since the last major bull market run through the end of the millennium raised the importance of return over the potential for risk, it has been estimated that the capital behind the carry trade has grown seven fold. This should not only offer some perspective into the overwhelming influence the appetite for risk has over price action across the markets; it more poignantly reveals how long the subsequent unwinding of this build up of bullish sentiment and positioning can last.

On the other hand, with the rise of risk aversion tightening the correlation between the currency and equity markets over the past six months, the link’s dependency on extreme risk sentiment has grown apparent. Eventually, volatility will cool and the demand for liquidity will subside. When this happens, not only will the correlation ease as traders can afford to once again be more selective with their trades, but there will also be an irrevocable change in this mature relationship. After the sharp downturn in markets and the collapse or near collapse of so many hedge funds and established banks, traders will no doubt be more cautious about their investment habits. This will likely develop into an explicit effort to avoid correlations between trades and prevent the same situation that has developed recently – at least for a while. Therefore, while this is an attractive tool, it is also one with a limited shelf life and should be exploited while it lasts.

Antonio Sousa is a Currency Analyst for FXCM.