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NO08 - How are the stocks and the forex markets related?

"When one talks about the forex markets, the general assumption is that it is an isolated market. But in reality, stocks and forex are part of the whole economic cycle. Therefore, what happens in the stock markets affects the forex markets and vice versa. At the end, the global economy transacts in their local currencies. There are a number of factors that can affect the valuation of a currency and its relative performance to another currency. In this article, we introduce you to the concept of how the stocks and the forex markets are related and why you shouldn’t look at them as two completely different markets. There is a strong interrelationship in the currency markets which can affect each other. The combined markets also influence the economy on the whole. At the end of this article, you will understand the role the forex markets play and how it affects other financial markets such as stocks and bonds."

So far, we learned a few concepts about forex markets and also pointed out the difference between trading forex and stocks. You have a fair understanding of what the forex markets are all about.

But actually, the markets (stocks and currencies) are closely interrelated. You might sound surprised at the mention of this. But think about it for a minute. The financial markets are all interrelated. In fact, what happens in one market can affect the performance in another market.

One might be forgiven for thinking that the stocks and the forex markets for example are different. Yes, they are in a way, but they are related to each other too. In the world of trading and analysis, there is a concept called inter-market analysis. The inter-market analysis is basically a study of one market to predict what would happen in the other market and vice versa.

To understand the relationship between stocks and forex, let’s get to the basics.

Relationship between stocks and currencies

Most of the company in a stock exchange (any stock exchange) create products and services. For the most part, these products and services are also sold overseas. In some cases, they may not be so direct, but in some way or another, they influence the final sale of the product in an overseas country.

So now let’s ask a question, what happens when the exchange rates fluctuate?

Let’s say you have a company ACME Inc. that is exporting goods. Its domestic currency is the USD. It imports all of its goods to Europe. Therefore, the company earns money in euros.

If the USD’s exchange rate is higher in value than the euro, then the company gets back smaller dollars in return, when they exchange the euro to the U.S dollar.

Now let’s say the USD’s exchange rate is lower in value than the euro. In this scenario, the company earns more in USD when it exchanges the euro currency.

As you can see, although ACME Inc. sold the same number of products, the exchange rate plays a big role. In the first instance, the profits earned are less, but in the second instance, the profits earned are higher.

In this example, ACME Inc. prefers a lower exchange rate for the USD so they can make more profits.

Now take an example of an importer who imports raw materials for their goods. If the domestic currency is in USD, then they prefer a higher exchange rate for the USD. This allows them to purchase more goods for the same value.

But if the USD’s exchange rate falls, it means that they have to spend more to import the same amount of goods.

In this second instance, the company profits more when the exchange rate is higher.

As and when the currencies fluctuate, you can see that it has a significant impact on a company’s profitability. This in turn affects the stock market as a whole.

How stocks and currencies are impacted

But there is also a converse relationship too. When an economy is rising, it means that the companies are earning more profits and revenue. When this happens, wages rise and the economy on the whole is chugging along smoothly, rising at a steady pace.

The central banks then use this booming economy to increase rates. When interest rates are increased, it makes the currency more valuable, creating more demand. The demand in turn tends to see the currency’s value appreciate.

On the other hand, if the economy is faltering and growth is declining, companies make less profits. This results in lower wages for the workers and thus the economy on the whole slows.

During such times, the central bank tends to cut interest rates and creates more supply in the market. When there is more supply in the market and interest rates are lower, it makes the currency fall in value.

You can now see how the stock markets and the currency markets are closely interrelated.

Traders make use of this information to assess the state of the economy. This in turn can give insights into what the country’s central bank will do. The decisions taken by the central bank eventually affects the currency itself and thus the exchange rate.

It is important to have a good understanding how the stocks and the currency markets are closely related. In fact, it is not just stocks but also the debt markets. Also known as the bond markets, these markets which deal in debt also impact the value of the currency.

The main takeaway from the above article is to understand that the currency markets are not isolated but that they are just as important as other markets such as stocks and bonds.

Read 841 times Last modified on Tuesday, 07 May 2019 10:47