How Equities Affect the FX Market

Foreign exchange (forex) traders are always looking for trends and economic outlooks to predict the potential movement in a currency. Some look at economic reports or GDP, or trade relations, but you might be able to predict these reports using the equity markets. Equity markets have thousands of firms around the world producing hundreds of reports every day that can be a useful source of information for currency traders.

Ultimately, a currency fluctuates based on supply and demand characteristics. When more investors demand a currency, it will likely strengthen relative to other currencies. When there is excess supply, the opposite is true. This fundamental principle, however, is influenced by many factors that lead to constant currency fluctuations each and every day. It is beyond the scope of this article to discuss many of these factors. The focus will be on how equity markets can provide an insight into the foreign exchange markets.

The foreign exchange markets are truly a global market – bigger than any other securities market. So when thinking about equities and their influence on forex markets, you truly have to think globally. The best companies to consider are naturally the ones with international operations that transact in various currencies. For example, as the biggest retailer on the planet, Wal-Mart deals with foreign exchange issues just as much as any other company you could think of. Another great name is Coca-Cola. These global consumer stocks transact with consumers all over the world and provide the best corporate glimpse into the forex market.

The commodities market can also be useful with respect to the forex market. Consider the main global commodity, crude oil. Global oil prices are denominated in U.S. dollars. As an example, the price of oil can spike because the value of the U.S. dollar declines relative to major global currencies. So the price of oil has to go up in order to equalize the price that other foreign countries buy in their home currencies. While other global commodities – sugar, corn, and wheat – offer similar insights, oil is the most significant commodity that relates to the foreign exchange markets.

A major equity market can also influence forex markets in another way. A weak currency favors exporters in that particular country. When your domestic currency is weak, exports are cheaper abroad. That helps fuel growth and profits of those exporters. When earnings are growing, equity markets tend to do well. Of course, the situation is most likely to occur in equity markets backed by the major global currencies – the U.S. dollar, the yen, the euro, and the British pound, among others.

Because foreign exchange markets are dynamic and fluctuate very quickly, most industries serve as lagging indicators for the direction of forex markets. It's not until a company reports its earnings that one begins to know the effect of currency movements. Often, the company's results will be vastly different than analysts' estimates when forex has played a major role. It is at that point that investors can analyze the comments from management with regards to the future outlook of currency fluctuations. Things to look for are any indications of hedging strategies that a company will take going forward.

Trying to differentiate what types of assets – hard or soft – best identify forex movements is meaningless. Rather, what is important is the necessity of the asset. Things like food, gasoline, and medicine would be more useful than clothing or jewelry. A company like Kraft, which sells food all over the world, would be more useful than Tiffany's, the iconic jewelry store retailer.

One would think that global financial institutions would serve a meaningful purpose in forex markets. They do in the sense that they help facilitate forex markets, but in terms of identifying direction, remember that the value of their main material – money – is influenced by government policy.

Unfortunately, equities don't provide any meaningful leading indicators. The value of money is determined by its supply and demand, which is generally determined by the government via interest rate changes or other policy movements. Trying to use equities as a leading indicator would not be wise when governments can influence movements at will.

The reality is that equities alone are not a prudent way to predict the direction of currencies. Government balance sheets, monetary policy and interest rates play a major role in forex markets. Recent U.S. history serves as an important example. As a response to the 2007-2009 financial crisis, the Federal Reserve significantly increased the money supply by buying over a trillion dollars in bonds.

While this program – commonly known as quantitative easing – helped the economy out of the worst recession since the Great Depression, the dollar weakened significantly against a basket of global currencies. This dollar weakening occurred even as U.S. equity prices surged from 2009 to 2011. Nevertheless, investors can look for patterns among these global companies.

There has been one major pattern that has emerged over the years. Many global businesses have been focusing their growth efforts outside the U.S. For example, in the late 2000s, coffee giant Starbucks outlined a plan to fuel future growth by expanding overseas. The company outlined plans to close 800 locations, most located in the U.S. Starbucks' focus on growing stores internationally worked out, and the company grew sales and profits and rewarded shareholders with a higher stock price.

But Starbucks isn't the only company that saw the writing on the wall: the best growth is coming from emerging and developing markets. Nearly all global companies have focused significant growth efforts in developing and emerging parts of the world.

The viewpoint of growth from abroad has coincided with a weaker dollar at the expense of other currencies. While it is no guarantee, strong economies are usually supported by strong currencies over the long run. Investors should clearly understand that short-term fluctuations are the rule, not the exception when it comes to foreign exchange markets. Of course, it's far from 100% accurate that a strong economy belies a strong currency. During the financial crisis in the U.S., the Japanese yen continued to strengthen relative to the U.S. dollar, even though Japan's economy had been in a funk for decades. But that was the yen versus the dollar and the U.S. economy at the time was falling faster than Japan.

Where global companies invest is often a leading sign that those companies see strong economic growth. Where there is strong economic growth, there is usually greater demand for the currency. More importantly, a strong economy often suggests a solid government balance sheet that helps support currency prices. When a nation is heavily indebted or has to continue issuing currency, the long-term effects on that currency are not favorable.

Forex markets are complex dynamic markets. Using one data point – such as equities – to forecast future forex directions can be a limiting exercise. Equities can be useful indicators, but investors should be aware that equities alone may not be sufficient to provide an accurate assessment.