Correlations Between the Stock Market and Carry Trades

[RichardCox 10]

A common mistake made by many technical analysis traders is failing to watch the ways various assets interact and perform under different market conditions. Some assets show incredibly high correlations (moving in a similar fashion at similar times), while others are inversely correlated to a near-perfect degree. This information can be highly valuable for traders because the price behavior forecasts that are required to make successful trades can be tailored (at least in part) based on the activity that has already been seen in related assets.

 

Historically, one of the best examples of highly correlated assets can be found in the stock market and in the carry trade, which pairs high interest currencies with low interest currencies. The strategy requires traders to buy a high yielding currency, using a low yielding currency as the funding asset. In these trades, investors can gain the dual benefit of favorable currency moves and the interest that is captured for as long as the trade is held.

 

Common examples of carry trades include AUD/JPY and NZD/JPY but the currency pairs that are used in these cases will depend on the prevailing interest rate levels at the moment. The Japanese Yen has offered extremely low interest rates for a long period of time, and because of this, the JPY tends to be the “go-to currency” for those looking to position themselves using this trading method.

 

Asset Performance During Periods of Market Stability

 

Now that we understand how the carry trade works, it is important to understand which environments provide the best opportunities to make gains using this strategy. To do this,we can look at opposing market scenarios. In the first case, imagine that price activity is rapidly changing because of widespread economic uncertainty. A good example of this would be the 2008 Credit Crisis, or the 1999 tech bubble in stock markets. In these cases, price activity was highly volatile and this tends to be unfavorable environments for both stocks and carry trades.

 

A quick look at chart activity during these periods will show extreme bearish declines, as investors looked to pull their money out of riskier assets and find protections in safe havens. Now imagine a second scenario, where price volatility is more subdued, and market fundamentals are showing more stable and predictable data releases. Excellent examples of this could be seen during the market rallies of the 1990s and in 2007. In these cases, the general stability of the financial world allows investors to take on additional risk (in order to increase the chance of enhanced gains). During periods like this, both stock markets and carry trades tend to perform well.

 

Applying this Behavior to Trading

 

The use of technical analysis is essentially an expectation that what has happened in the past is likely to happen again in the future. With this in mind, trades can be taken based on the market environment that is currently in place and on the ways these different assets have performed with respect to one another. For example, stock markets are now approaching their highest levels in 5 years, which leads many traders to look at stocks as overbought and in danger of a downside reversal.

 

This trading bias can be applied to highly correlated currency pairs (such as the AUD/JPY), and major breaks of support will then be viewed by many as being more credible, creating a better chance of significant follow-through. Hypothetically, the opposite scenario (a large scale bear market in stocks) would be viewed by many as a buying opportunity in currencies like the AUD/JPY if upside breaks of resistance were seen. This bullish bias would be based on the idea that a heavily correlated asset (the stock market) is oversold and is ready for an upside correction.

 

A Look at the Historical Correlations

 

In the attached graphic, we can see the historical correlations between one of the most popular carry trade currencies (the AUD/JPY) and the most commonly traded stock index (the S&P 500). When looking at correlation tables, a reading of 1 indicates perfect asset correlation (prices of both assets move in “lockstep” 100% of the time). A reading of 0 indicates both assets have no correlation (move randomly with respect to one another), and a reading of -1 means that both assets show perfect negative correlation (move in opposing directions 100% of the time).

 

Looking at the correlation chart, we can see that the AUD/JPY and S&P 500 show a reading close to 1 for most of the charted time period. Over the 6-year period, there are only three brief intervals where this correlation breaks down into “random” territory and, on the whole, this suggests a highly reliable relationship that can be used as additional information when trades are placed. Of course it should be remembered that these relationships can change.

 

If, for example, Australia decided to drop interest rates to 0%, the AUD/JPY would no longer qualify as a carry trade (and the correlation relationship would no longer apply). For this reason, it is unwise to base trades solely on these types of correlations. A more prudent approach is to use these relationships in conjunction with other forms of technical analysis in order to improve probabilities for gains. The main point to remember is that correlation tables that show asset relationships closer to 1 (or even -1 for opposing trades), tend to provide the most reliable signals.

 

Using Inverse Correlations

 

A final point to remember is that we are not limited to assets with positive correlations when structuring trades. If fact, negative correlations can be equally valuable as long as we understand what this relationship suggests. For example, Gold is typically though as as a safe haven asset, with a negatively correlated relationship with JPY carry trades. In these cases, technical events that are bullish for Gold should be viewed as bearish for carry trades (such as the AUD/JPY or NZD/JPY). In a hypothetical trading situation, occurrences like oversold conditions for Gold would actually suggest future selling pressure for carry trades, as a bullish correction in Gold would become more likely. Conversely, overbought conditions in Gold would suggest that pairs like the GBP/JPY are likely to experience a rally going forward.

 

Conclusion: Understand the Relationships between Different Asset Classes

 

Currency correlations provide traders with valuable information that all types of strategies can utilize. Calculations like correlations tend to be used more by fundamental traders but it is important for technical charting traders to understand these developments as well. Anything that can turn the odds in your favor when placing a trade should be used and acted upon, and the performance of correlated (or even negatively correlated) assets can signal some key ways trends are likely to develop in the future.