A market correlation is when two markets move together. This could be in the same or opposite direction. Understanding the how and why it occurs is can help you identify the future price direction of an instrument.
Correlations are never 100% accurate and can break down under different market circumstances but when used right they can can help you make better trading decisions.
Let’s look at a major contributor related to two major instruments (The US Dollar and Gold)
The Negative Correlation between the US Dollar and Gold
The US dollar and Gold move in opposite directions (negatively correlated). The graph at the top is the USD/JPY pair and we have the gold chart at the bottom. Here we see 7 years of price history. An opposite movement.
So why is this?
When markets are performing well investors will always chase the best yield available and if the best yield is coming from the stock markets, investors will invest their money there.
You can only invest in US equities with US dollars so to do that these investors need to buy US Dollars. This increases the demand for the US Dollar which pushes up the price of the US Dollar.
Gold is considered a haven asset class: however, it does not offer a yield. When stock markets are rising investors will sell their gold holdings to access this better yield which will result in the price of gold falling. So, dollar rises and gold falls.
A third consideration in this correlation is the Japanese yen which is also considered a haven asset in times of uncertainty. However, in our example above if stocks are rising money will also flee from the Yen which is why we are using the USDJPY pair in our example.
Not only are investors buying the Dollar to access the stock markets buy also selling the YEN as they do not believe a haven such as the YEN is needed when stock markets are rising.
Below is a more recent example of the negative correlation between the USD and Gold over the last 10 days (16th Feb – 26th Feb 2018)
There will always be other variables going on such actions from Central Banks that will impact these correlations and expose them as not being perfect all the time.
That said, nothing is perfect in trading, it is all about connecting different pieces of useful data and using it to help you make better trading decisions. Correlations is just one!
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