Why Fx Traders Should Pay Close Attention To The Stock Market This Quarter
We all know that the forex and stock markets are linked, thus forex traders should keep a watch on what stocks are doing. However, there are a few situations this quarter that make this link much more evident. The stock market, particularly in the United States, may provide some clues as to what to expect in the currency markets.
What's going on?
To have a better grasp of the issue, keep in mind that bonds are one of the main ways the stock and currency markets are linked. When bond prices fall, for example, investors rush to purchase that currency. This raises the currency's value about other currencies. At the same time, investors are exiting the stock market to purchase bonds. This implies that the stock market will fall.
As a result, the traditional inverse link between currencies and the stock market exists. That doesn't always match up perfectly since it relies on why bond prices have fallen. Another important issue is risk sentiment. Because stocks are riskier, when there is a risk-off market, investors will exit the stock market and purchase bonds.
What is causing the underlying market to rise?
The problem is that the bond market is currently severely skewed, notably in the United States and Japan. This is because authorities have been meddling in the market over the previous few years. Almost all central banks and governments have done so, while some have done so more than others. As a result, there may be a disparity in currency reactions.
Governments released large quantities of debt in the form of bonds during covid. Due to supply and demand, this would generally cause interest rates to rise. However, central banks intervened by purchasing bonds in an attempt to drive interest rates lower. In the bond market, this creates an artificial scenario.
Following the distortion
Bond yields are naturally used to illustrate relative risk. That is, the greater the interest rate, the longer the bond period. This is known as the bond yield curve. However, central banks such as the BOJ and the BOE have intervened to "regulate" the yield curve. The US bond curve is "inverted," which means that short-term debt has a higher interest rate than long-term debt, reflecting central bank policy expectations.
Why it is significant
Investors will place their money where they feel the risk-reward ratio is the best. Bonds are less risky than stocks, thus the higher the interest rate, the greater the interest in selling equities. Investors have a distinct incentive structure if the central bank is manipulating the market. This can result in a stock market run-up while conditions aren't so excellent, such as in 2020-2021, followed by a stock market slump when things improve, such as in 2022.
As a result, central bank policy can trump economic facts. The Fed is anticipated to pause or cease raising interest rates this quarter. If the Fed maintains its current stance, the market's natural dynamics may resume. As a result, the stock market may resume its more traditional function of anticipating sentiment. This, in turn, offers insight into how much demand there is for bonds and whether a certain currency will gain or depreciate.