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The interdependency between the financial markets

01 Financial Markets Interdependency

If you think that trading forex is all about focusing on just one currency pair or an instrument, then wait until you learn about inter market dependency. In the financial markets, no asset trades in isolation. Almost all the times, you will be able to find a relation between the behavior of one asset or instrument to another.

This is the fundamental basis of trading in the financial markets, regardless of whether you are trading forex, or equities or derivatives.

Understanding how market sentiment works

The reason behind this is because the market sentiment, or the investor appetite can be defined into a binary form of rising risk appetite or falling risk appetite.

What this means is that when investors are confidence, they are bullish on risk. Thus, it leads to the riskier assets outperforming the less risky assets. Generally, the rule of the thumb is that the returns are much higher for risky assets compared to non-risky assets.

On the other hand, non-risky assets then to safeguard your principle.

It is not surprising then that assets such as fixed term deposits, or investments in government bonds yield lower returns. But this lower return is compensated in the form of your principle being guaranteed.

02 Correlation

Market Correlation (Source: MyFxBook.com)

The rising and falling risk appetite in investors

When you look at the riskier assets, there is no guarantee that your principle is safe. On the other hand, the returns are much higher. You might have come across the term risk on, risk off. What this means is that when the investor sentiment is high, it is classified as a risk on market. In these conditions, the riskier assets tend to outperform the less risky assets.

Likewise, when investor sentiment is less confident, they move to the less risk assets. In such a scenario, the risk off sentiment will often see the less risky assets outperforming.

Thus, there is a trade off between the two. Equities and bonds.

Knowing the above information, traders can now use this to their advantage. While this won’t give you the edge in the markets, it helps to improve your confidence.

The Risk on Risk Off effect in the forex markets

In the forex markets, one can also see the effects of risk on or risk off effect. Typically, the U.S. dollar tends to fall during a risk on scenario. Other currencies include the Japanese yen and the Swiss franc.

These currencies are often known as the safe haven currencies. Thus, when investor sentiment is high, there is a search for higher yield. Currencies that offer a higher interest rate comparing to the U.S. dollar tend to outperform.

Recently though, currencies such as the Australian dollar and the New Zealand dollar have had lower rates than that of the United States. Still, these currencies tend to fare much better during risk on rallies.

At the same time, the safe haven currencies tend to pullback. Thus, one could find currency pairs such as the AUDJPY, NZDJPY, GBPJPY being more bullish.

Similarly, when the risk sentiment falls, investors rush to the safe haven assets. Thus, from a forex perspective, investors can look to the same currency pairs (AUDJPY, GBPJPY, NZDJPY) being better a short selling.

This is because the safe haven assets such as the JPY and the CHF tend to outperform the riskier assets.

You can easily correlate these trends when comparing the currencies or the currency pairs to the asset classes such as equities and bonds.

When the JPY for example is stronger, you will see that bond yields tend to rise higher. At the same time, equities tend to be weaker.

When the JPY is weaker, you will see a strong correlation to lower bond yields while the equity market returns outperform.

The status of the USD currency

An important point to note here is the U.S. dollar. The dollar can sometimes act as a safe haven currency that can defy logic. Generally, when there is a crisis outside the United States, the USD tends to take the role of a safe haven asset.

In such cases, any currency against the USD will be weaker. Conversely, during a crisis within the United States, the Japanese yen takes on the role of a safe haven asset. But there are times when despite an internal crisis, the USD outperforms. This is due to the full faith and credit of the United States government which backs the U.S. dollar and also the U.S. bond markets.

In conclusion, the interdependency of the markets can be easily seen by means of the correlation chart among the currency pairs and other asset classes. Using this information, traders can further build confidence in their trading positions.

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