Foreign exchange traders, both seasoned and new, heavily focus their trading strategies on technical indicators – moving averages and trendlines– when trading the euro or British pound. And, they rarely take a look at other markets for additional hints in market direction. But, these other markets can sometimes hold the key to a profitable position or a losing trade in the foreign exchange market.

Tutorial: The Ultimate Forex Guide

For years, professional money managers have looked at secondary markets for confirming a position. Using advanced charting programs, these professionals are able to see relationships between certain markets – revealing movements between investments in the same or different direction. Some of these correlations are commonly known to the market - crude oil and the Canadian dollar or gold futures and the Australian dollar. And, some are not so common – like the U.S. dollar/Japanese yen exchange rate and short-term rate on Japanese government bonds.

Let's take a quick peek at some other markets that can offer insights into potential foreign exchange market moves.

Look to Bond Yields
Believe it or not, currency and bond markets are very closely related.

The direction of both investment assets is widely dependent on a country's economic environment and monetary policy. If an economy is showing strength, global investors will buy bonds that are being offered by a particular country – always looking for stable and high rates of return. This will cause demand for the country's currency to increase, thus appreciating the value of the currency. Global investors interested in investing in the country (and its infrastructure) will always have to transact in the country's currency. They go hand in hand.

This is the reason why money managers will watch short-term bond yield patterns for confirmation of a forming trend in the currency market. A movement in one asset can foretell or confirm the move in another asset. (Find out what these common ways are so that you can avoid them - and the losses that follow. Check out Top 8 Ways Lose Money On Bond.)

One currency pair that shows off this relationship is the U.S. dollar/Japanese yen exchange rate. In the FX market the USD/JPY currency pair moves in relative sync with short-term Japanese government notes – particularly Japan's two-year notes. In Figure 1, we can see the pattern was particularly strong throughout most of 2010. During this time, market speculation had sided with an appreciation in the Japanese yen. With hints of a global recovery surfacing, Japanese exporters were rebounding faster than their U.S. counterparts – leading to higher growth in Japan. As a result, global investors betting on better prospects in Asia invested in Japanese short-term debt. The demand helped to boost the Japanese yen's appreciation against the U.S. dollar from May to September 2010.

Figure 1
Source: Bloomberg

Currency Futures
Derivative instruments - like currency futures - are also great in confirming short-term trends in foreign exchange rates.

In the equity markets, stock brokers and traders will look towards market volume in confirming momentum. Currency traders, instead, will use currency future open interest in gauging the market's demand for a particular currency. This type of information can be used to predict the future demand not only for currencies, but commodities as well.

Although some analysts or strategists look at both non-commercial and commercial transactions – the key is to look at non-commercial positioning. Non-commercial positioning is usually done by entities that are speculating in the market. The trick here is to see pent-up demand in a particular currency in confirming or hinting at a potential direction in the market (i.e. two-month open interest high in the Australian dollar). For instance, significant interest in a currency means that a good portion of the market is on one side of the market – making the opposite outcome more probable. If every trader is bullish or long on the market, what happens when they all want to sell? (The forex market is not the only way for investors and traders to participate in foreign exchange. Discuss Currency Futures.)

On December 19, 2010, euro bearishness reached a significant 90-day high. Traders were betting on dollar strength as the European Union debt crisis lingered on, and these traders were short euro currency futures. This tidbit coincided with the EUR/USD currency pair falling to a technical support level of $1.3080. Shortly after reaching the level, traders began to take profits – which led to a reversal of sentiment. Euro strength continued in the days after the bullish signal surfaced – creating a 10% return for euro longs.

Figure 2
Source: FX Intellicharts

Credit Default Swap Markets
A relatively unknown market, credit default swaps or CDS instruments can be great in showing long-term sentiment for individual currencies.

Introduced and widely used in the last 14 years, credit default swaps are contracts protecting a buyer's position against a potential credit event. For example, a money manager can insure the creditworthiness of $100 million in Japanese government bonds by paying an insurance premium. In the event of a default or debt crisis, the money manager would be able to recoup the value of their bonds. So, much like currency futures, credit default swaps are a great way of telling how bullish or bearish the market is on a particular currency.

During the European Union debt crisis of 2010, credit default swaps confirmed the market's distaste for European assets – credit default swaps (or the cost of insurance) shot to record highs. Industrial nations like the United States and Great Britain, today, enjoy swap rates of 50 basis points on average. Greek swap rates were over 15-times these rates during the debt crisis. Vast differences between the credit swaps rates confirmed bearish sellers in the Euro as the currency plummeted by 20% in as little as 5.5 months.

When used correctly, these market indicators can add great confirmation to individual trades – boosting overall investment return. With the increased interconnectivity of the global markets these days, it pays to understand market relationships. And, it helps investors to profit greatly from them. (Many spot currency cross pairs are not traded against each other directly. Here's how it works. Check out Currency Cross Triangulation.)

Related Articles
  1. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  2. Investing Basics

    3 Key Signs Of A Market Top

    When stocks rise or fall, the financial fate of investors change, as well. There are certain signs that can reveal a stock’s course, and investors don’t need to be experts to spot them.
  3. Investing

    Oil: Why Not to Put Faith in Forecasts

    West Texas Intermediate oil futures have recently made pronounced movements. What do they bode for the world market?
  4. Investing

    Asset Manager Ethics: Rules Governing Capital Markets

    The integrity of the capital markets needs to be kept at utmost importance for all investors. This article shows how to maintain the integrity while investing.
  5. Economics

    Is the U.S. Economy Ready for Liftoff?

    The Fed continues to delay normalizing rates, citing inflation concerns and “global economic and financial developments” in explaining its rationale.
  6. Economics

    The 5 Countries That Produce the Most Solar Energy

    Discover which countries are taking advantage of solar power and how they are implementing systems to use solar as a viable source of energy.
  7. Mutual Funds & ETFs

    The Risks of Investing in Inverse ETFs

    Discover analyses of the risks inherent to inverse exchange-traded funds (ETFs) that investors must understand before considering an investment in this type of ETF.
  8. Mutual Funds & ETFs

    Top 4 Inverse Equities ETFs

    Explore analysis of some of the most popular inverse and leveraged-inverse ETFs that track equity indexes, and learn about the suitability of these ETFs.
  9. Forex Fundamentals

    Oil & Currencies: Understanding Their Correlation

    Crude oil shows tight correlation with movements in many currency pairs.
  10. Forex

    How Much Leverage Is Right for You in Forex Trades

    It isn’t economics or global finance that trip up first-time forex traders. Instead, a basic lack of knowledge on how to use leverage is at the root of trading losses.
  1. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  2. Is Japan an emerging market economy?

    Japan is not an emerging market economy. Emerging market economies are characterized by low per capita incomes, poor infrastructure ... Read Full Answer >>
  3. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  4. How is the value of a pip determined?

    A pip in foreign exchange trading is a measure of a price movement in a currency pair. "Pip" is an acronym for price interest ... Read Full Answer >>
  5. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  6. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!