Find out what Brexit could mean for the markets and how a hard or a soft exit from the EU could affect traders.
Forex and stocks are two of the most traded financial markets in the world, so it is common for traders to look for correlations between the two markets that might help them to predict future price movements. But few conclusions have been drawn over which market leads: does the stock market influence exchange rates? Or does forex influence share prices?
The basic theory is that when the domestic stock market rises, it gives investors confidence that the country’s economy is also rising, leading to increased interest from foreign investors and demand for the domestic currency. Conversely, if the stock market underperforms, confidence falters and foreign investors take their funds back to their own currencies.
There have been cases where this appears to be true, when the performance of a stock market impacts the price of a currency pair. For example, the Nikkei stock exchange in Japan has historically exhibited an inverse relationship with the USD/JPY currency pair, meaning a rally in the Nikkei would often lead to a strengthening of the yen against the dollar. This was because investors saw such a rally as a sign that the Japanese economy was gaining momentum and would pull their money out of the US dollar to put back into the yen. The increase in the price of the yen would cause the USD/JPY pair to decline as the dollar weakened relative to the yen.
Many traders began to see the Nikkei index as an indicator for the future of the USD/JPY pair – buying USD/JPY when the Japanese economy appeared weak and selling USD/JPY when the Japanese stock market showed signs of strength.
However, in reality the relationship between the Nikkei and USD/JPY is more complicated. When the 2008 global financial crisis hit markets, the correlation completely changed to become positively linked, with the stock market moving in the same direction as the currency pair. This change has largely been attributed to a change in market sentiment, as investors began to look at the yen more positively after the crisis.
The changing correlation shows us that there is no perfect science to the relationship between stocks and forex. This doesn’t mean that there is no relationship between the two markets, or that the relationship is useless, it merely demonstrates that it is important for traders to look at a wide variety of indicators before deciding how to trade.
One explanation of the relationship between exchange rates and stock prices is the ‘portfolio balance approach’, which advocates that the causality runs from exchange rate to stock prices. It is based on the idea that the market value of firms can be significantly affected by the health of the national currency. It suggests that when a country’s currency is weakened, its exported goods become cheaper internationally, which can help to fuel growth and lead to a potential increase in profits for companies whose earnings are export based.
A popular example of the correlation between forex and shares is the FTSE 100 stock index and British pound sterling. The index is impacted by the direction of the national currency because a lot of the listed companies have international operations, so a large portion of their profits are made in US dollars or other currencies. If sterling weakens then the dollar revenues are worth more and the FTSE 100 is likely to rise as the companies on the index become more valuable.
However, it is important to remember that the forex market is extremely volatile, so any impact upon the stock market tends to lag. Also, until a company releases its earnings report we can’t fully understand the extent to which currency movements have impacted upon their operations and share prices. Even though the correlation between exchange rates and the stock market does exist, it can be difficult to use as an indicator for share price movements.
There are certain phenomena that make it easier to see how the stock market and forex market interact – two commonly used examples are Brexit and the health of emerging market (EM) economies.
After the United Kingdom (UK) decided to leave the European Union (EU) on 23 June 2016, the British pound fell immediately. The declining currency, in turn, boosted the share prices of big UK-listed companies with global operations, such as GlaxoSmithKline. As these companies generate large amounts of their profits overseas, the currency adjustment meant that their profits rose when converted into sterling. The perceived increase in the companies’ revenues caused their share prices to rise. For example, shares of GlaxoSmithKline had been trading at approximately £1387 a week before the vote, and hit highs of £1709 in the month that followed.
However, as the reality of Brexit settled in, a lot of the same companies saw their share prices decline as the fall of the pound increased inflation. Consumers were squeezed by the higher prices of goods, and so they started to spend less, which meant that revenues fell. To continue the above example, by the end of 2017 GlaxoSmithKline’s share price had returned to a pre-Brexit level of £1380.
When trying to establish a causal relationship between forex and stock prices in EMs, the connection is slightly easier because the dollar remains one of the most important considerations for emerging market finances. The health of EM stock markets are closely tied to the fortunes of the US dollar. This is due to the impact of ‘capital flight’, which is when capital flows out of EMs and back to the US, and the reliance of EMs on commodity exports, which are dollar-denominated.
In general, a strong dollar tends to cause lower stock prices in emerging markets. This is because as the dollar rises, everything that is denominated in EM currencies becomes cheaper, including the domestic stocks.
However, when an EM currency falls in value compared to the dollar, the cost of imports will rise, which can heavily impact companies who rely on imports for materials and may impact their share prices.
Although no definitive relationship has been proven, there are plenty of correlations that have piqued traders’ interests over the years. As both forex and stocks have a crucial role in business all over the world, it is likely that academics and analysts will continue to try and understand the relationship between exchange rates and share prices.
While looking at specific examples can be a great way to see the two markets interact with each other, it is important to remember that there is no guarantee these patterns will be repeated over time. Using a single data point, especially one as prone to change as the relationship between forex and stocks, can be extremely risky. Traders and investors should consider multiple indicators when they are making decisions about what to trade and when to trade it. The forex market can be an interesting factor to consider when looking at stocks, but alone it is not enough to provide an accurate assessment of market movements, and vice versa.
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