Using currencies to time equity moves

For the finance director timing currency trades for stock or sales deals can add substantially to the bottom line. Now this converse strategy can have benefits for pensions' investment, foreign adventures in merger and acquisition policies or even financing oversea deals.

Considering the currency market's deep liquidity and 24-hour trading cycle, overlooking any advantages would be missing out on the benefits of the 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 on their particular market. This creates a huge gap of time where a release of economic information or an exogenous event that effects the general appetite for risk can become common without being incorporated into stock prices. The only reprieve for pure equity traders is to anticipate a stock market's reaction to data or breaking news or monitor other indices' reactions to the data: a highly inefficient policy. Additionally it is common for these smaller equity markets not to react until a financial centre, like London or the US, opens and reacts.

A very clear example of the currency market's ability to lead equities can be seen in the after-session hours of 6 November. News that Morgan Stanley would take another $3.7bn 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 USD/JPY. However, with the American stock markets closed, 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 the forex market reaction 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 futures on the benchmark equity indices as a forecasting tool for price action in the stock market's active session. This comes with some limitations: futures usually have a limited response to an event risk because of a longer investment time horizon and 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 it is likely to have a sustained impact. The primary basis for the 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, much higher than even the most active futures market. What's more, considering the New York Stock Exchange's average daily trading value is $141bn, the currency market is more adept at efficiently absorbing data. 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 to be 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 seen a greater synchronisation between the currency and stock markets on the intraday level.

Since the last major bull run at the beginning of the millennium, we have seen strategies highlight the importance of return over the potential for risk, and the carry trade has seen its assets under investment increase seven-fold. This fact offers perspective into the overwhelming influence of risk appetite over price action across the markets and more poignantly it reveals how long the subsequent unwinding of this build up of bullish sentiment and positioning can last.

Over the past six months with the rise of sentiment that is averse to risk comes a tightening of the correlation between the currency and equity markets and the links 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.

John Kicklighter is a currency analyst for DailyFX.com