3 Key Markets To Follow When Trading FX

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.

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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.)