How Divergence In Correlated Assets Can Help You Add An Edge To Your Trading

Did you know that each forex pair has a series of highly correlated assets that can add an edge to your trading? This type of study is called inter-market analysis and it involves scoping out anomalies in the ever-evolving global interconnectivity between equities, bonds, currencies, and commodities.

In this guide, I will elaborate on the essentials you need to know to stay one step ahead and be able to constantly assess the value of a currency as it compares to a basket of correlated instruments.

Before that, you must be aware that due to globalization and the progress in technology (trading algorithms, quant models, etc.), markets have become increasingly intertwined. Interconnectivity is everywhere and financial markets are no exception, which makes the right interpretation of these relationships key. One must have, however, an open-mind to interpret these links as correlations are constantly evolving depending on market conditions.

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The Basics: A Plethora Of Elements Play A Role, Bond Yields Are King

As a trader, you must be aware that there is a myriad of factors having an impact in the value of a particular currency, from capital flows a country imports via its equity market, the seek for higher returns on government bonds, fundamental reasons based on economic data, risk sentiment, speculative flows, M&A flows, the discounting of certain events, etc.

The above factors not only have a direct influence in currencies but also on the performance of other assets such as equity indexes, government bonds yields, commodities, and other assets. This provides a frame of reference to identify ‘fair-value’ relationships among certain instruments and the divergences that often exist, which create opportunities to exploit.

Let’s begin by building a solid foundation to provide sufficient evidence of the strong relationship that certain currencies have against other instruments. We will start by providing a research report by Nomura, one that I’ve been following for many years, in which their analysis team measures the correlation dynamics (3-day returns on a 3-month period).

Do you notice the instruments most correlated to currencies? That’s right, the appeal for yields via interest rate differentials. The fluctuation in government bond yields is mainly a function of two scenarios. It can be based on interest rate expectations or driven by what’s often referred to as a ‘flight to safety’.

In most cases, the yields a government bond pays will closely track the outlook for interest rates set by the country’s central bank. Bond yields will tend to rise when the central bank goes through a rate hiking cycle as the appeal to invest in fixed income diminishes. This causes the bond to get sold, which makes the yield be an inverse function of the bond price, adjusting higher to the next point of equilibrium.

The opposite is true when the central bank resorts to an expansionary policy of lower rates. Government bonds become more appealing to an investor, which leads to higher prices, and consequently, yields adjusted lower. In closing, government yields, barring episodes of risk aversion, tend to fluctuate based on the interest rate outlook of that country.

As an example, in the case of the US, its current economic bonanza has resulted in the need by the Fed to increase the interest rates, making deposits in banks more attractive as a tool to hold down risks of inflation. As a consequence, there is an increase in government bond supply, which leads to higher interest rates paid by the bonds to reach the next point of equilibrium.

After all, the old-fashion term ‘carry trade’ in the forex market originates from the attractiveness it has for market participants to tap into an interest rate arbitrage strategy. The nuts and bolts of the strategy entail to borrow capital in a low-yielding currency and invest the funds in a country with a higher yielding currency. A clear example, as the global context stands, is to borrow in yen or euro paying a paltry rate and invest the funds in USD-denominated assets. Since the Fed is currently embarked on a tightening cycle paying higher interest rates at 2%, it makes for an attractive strategy.

In certain currencies, the behavior in equity markets and/or commodities also plays an important role, even greater than the bond yield spread. But, by and large, the differential in the interest rate paid by government bonds, as a barometer to gauge the outlook in monetary policies, is the benchmark that the market gets fixated with in order to determine the value of a currency.

Large players in the forex market such as investment banks, hedge funds, institutional investors and large commodity trading advisors (CTAs), with a direct exposure to global markets, are constantly seeking to benefit from countries with the highest yields while considering other aspects such as a low risk of default. The rule of thumb here is that the currency with the highest government bond yield spread will tend to benefit if, as I will describe below, the context is also conducive.

That’s right, the search for attractive interest rate spreads in different countries must take into account the market context. If optimism and a generally positive mood exist — ‘risk appetite’ — this is manifested by the reshuffling of portfolios into higher-risk assets (rising equities/commodities, lower government bonds/volatility). Under this context, it is constructive to exploit discrepancies in rate differentials. On the contrary, if ‘risk aversion’ is present, which is associated with pessimism and uncertainty, it will be reflected by lower equities, higher bonds/volatility and see a bid in the yen/Swiss franc/US dollar as safe havens. During this phase, the market will go into capital preservation mode and temporarily disregard the advantage in interest rate differentials in certain countries.

At the end of the day, the moves in the forex market, in its simplest form, are a function of capital flows between countries and the risk sentiment that exists. The interpretation of these two components can allow you, as a trader, to increase the odds of success by exploiting Intermarket divergences.

Data-Backed Examples To Demonstrate These Correlations

Let’s now start separating different markets based on the instruments each is most correlated with. Based on the activity on these correlations, you will be better positioned to understand why currencies move the way they do and make the right interpretations of the moves seen in forex.

Firstly, this is a 3-day chart of the EUR/USD that goes back all the way to the GFC of 2008. I’ve overlayed in red the German vs US 5-year bond yield. One can use the 10-yr bond yield spread instead. Over the years, I found no major differences in accuracy, so pick whichever you like.

As one can notice in the 2nd window also in red, I’ve added a 30-period correlation, so essentially what it measures, as in the case of Nomura’s model, is a 90-day correlation based on a 3-day return. And what do you notice right off the bat? Notwithstanding a few periods of obvious divergence in correlation, by and large, the strong relationship between the two instruments should leave no ambiguity about the accuracy in its linkage. For the last 10 years, the yield spread shows an overwhelmingly positive correlation. It exhibits a correlation above 0 over 85% of the time.

As an extra bonus insight, the brief spells of time when the instruments show disparity, more often than not, tends to coincide with periods where other drivers such as risk sentiment have a greater influence. In the case of the EUR/USD, one of the latest episodes, where it temporarily detached from its bond yield spread differentials, came as a response of France’s Macron victory in the presidential election in mid-2017. In the case of Macron, the event removed such a high existential risk for the EUR over the prospects of Le Pen’s far-right party coming to power, that a sentiment play prevailed above bond yield differentials. That’s why being in tune with the markets to understand the context one is trading under at all times is so critical.

What about the Sterling? In the case of the British currency, not only the yield spread should be monitored, but I also suggest to keep a close eye on the DXY (US Dollar index). The performance of the index (EUR/USD inverted) tends to determine the direction of the rate with even more accuracy than the bond yield spread itself. When both combined, it’s when it results in the most insights. Be warned, we are going through exceptional times in the UK due to Brexit, and this entails significant risks of going through rough patches of purely politically-driven moves not resonating with correlations.

On USD/JPY, since the yen is one of the currencies, along with the Swiss franc, most sensitive to sentiment, I’ve also added a black line to measure overall risk in the market. It equally-weighs the S&P 500 (inverted VIX), US 30-yr bond yields, gold, and the DXY. The equation, as of Sept 13th, 2018, reads “SPXUSD/2871+US30Y/3.09-XAUUSD/1194-DXY/95.21.” It includes in the numerator the name of the asset, while the denominator is for the value of the asset. The result is an overlaid line in constant fluctuation.

The reason I incorporate the risk sentiment line is that in times of risk aversion, a drop in the black line will communicate that the pair is getting expensive from a risk sentiment perspective, as investors tend to buy the yen as a safe-haven asset. Meanwhile, a rising index communicates the dominance of ‘risk on’ flows, which should benefit JPY crosses.

Let’s now look at the AUD/USD. As the chart below exhibits, the most obvious correlations include the bond yield spread and the performance of DXY and gold. While divergences exist, the overall relationship is very strong. In the case of the Australian dollar, I’ve added gold because Australia is one of the major exporters of the shiny metal, with higher prices in the metal benefiting exporters, and subsequently, helping to expand the economic activity.

Another relationship to monitor is USD/CAD and its links to the bond yield spreads and Oil prices. Canada is a major oil exporter, with over 85% of its exports going to the US. The higher Oil goes, the better for Canadian exporters, and this assists the overall economic activity. Notice, in recent times, the bond yield spread has dethroned Oil as the most correlated instrument. As in the case of the Sterling, is always best to track the performance of both. The avid trader may want to combine in one single formula ((US05Y-CA05Y)/value spread) — (OIL/value oil) to simplify it.

In the case of the NZD/USD, since New Zealand is a country rich in natural resources, it benefits from a rise in general commodity prices, especially those related to the agricultural sector. New Zealand is highly dependable on the sale of its commodity products such as dairy, meat, wool, etc. The same logic applies here, when prices of commodities rise, exporters get a boost in earnings, which in turn helps the economy. That’s why a useful index to monitor is the CRB Thomson Reuters index, which encapsulates the performance of a large basket of commodities to gauge the overall direction. At the same time, the proximity of New Zealand to Australia makes the Kiwi vs gold a correlation to monitor closely too, given that an increase in the price of gold will provide a boost to its neighboring country, and New Zealand should also pick up momentum. One can also notice that the correlation between the Aussie and New Zealand is extremely strong.

How Can One Benefit From These Relationships?

Leaving aside the carry trade strategy, which is a technique more susceptible to risks in the exchange rate differentials when the proverbial hits the fan and risk conditions deteriorate, the most compelling opportunity that such relationships offer is to look for divergences amongst instruments.

While the theoretical part up is important and hopefully was explained with sufficient eloquence, let’s get into the nitty and gritty by taking it one step further and provide a few ideas, based on my own trading experience, on how to strategize one’s approach to take advantage of these divergences.

Here it goes. I always look for the same type of price pattern — explained below — with three major components that determine my risk level, assuming we have a divergence in correlations to start with. These elements include the cycle of the market — I refer to the cycle in a higher timeframe -, relevant levels with enough interest, and fundamentals of the currency. You then must figure out enough risk-reward, pull the trigger and stick to a specific risk management plan. That’s the inner mechanics of how I personally process my trades. Below, l deconstruct the trade process further.

I like to go through a mechanical process where I first let the market go into overbought or oversold conditions based on the RSI 13 period — it can apply to any time frame -. After that happens, I need to assess if the area is relevant enough from a technical perspective (testing an important moving average, round number, macro support or resistance?) and whether or nor the trade is in line with a higher timeframe cycle or against. An answer to these questions allows me to determine the risk levels worth taking.

Next, as in the two trades illustrated in the chart, I need to see a counter-move away from ob/os conditions sufficiently strong to make me think enough interest exists to reverse the prices back to the mean. This is measured by the price touching — aggressive — or closing above the 21-ema — conservative -.

If I can tick the box on this condition, I then must keep an eye on the correlated instruments — bond yield spread or others — for a potential divergence with price. A question must be asked at this stage: Is there a divergence between the price and the correlated instrument (German vs US yield spread) as price retests the most recent lows (#1) or recent highs (#2)?

Personally, I like to see a break of structure in the correlated instrument, as it’s the case in the examples and illustrated in a magenta horizontal line. Notice, by the time the yield spread breaks higher in #1, EUR/USD is still trading near the last swing low. The opposite is true in #2, as the break of the recent lows in the yield spread finds the price still retesting the last swing high.

Once you pull the trigger, which would have been on the vertical purple line drawn, the management of the trade comes next. This is a realm very personal and it depends on your own approach to risk. Note, you must be consistent in how to manage your risk for the most optimal results. It’s not about the potential upside — that will take care of itself — but what must happen that will negate your view on a positive trade outcome? I leave this one up to you, as there is a multitude of different approaches one can utilize.

Below is another example, which this time doesn’t go our way. Again, when engaging in trades, even more important than the process described above, is understanding the trading context and market structure. You need to ask yourself, under what environment are you trading (risk-on, risk off, sentiment-led, etc) and whether or not you are trading with the current market cycle or against, leaning against an important level or in no man’s land? Another aspect to take into account is whether or not you are trading the currencies’ session. The bottom line is, one must put into context and take care of the when, where and how a divergence occurs in the chart.

One more example can be found in the USD/JPY. Note, in the chart below, I don’t incorporate the risk-weighted index I previously described as to keep the exercise as simple as possible. Do you notice when USD/JPY retests the prior swing low, the 10-yr US vs JP bond yield spread has broken higher? That’s the cue I need to engage in longs at the vertical line.

Find a recent video I put together on the subject:

Another strategy one could look to exploit involves engaging in retracements every time there is an impulsive price transition that successfully breaks into new higher highs or lower lows. As a trader, you must then compare the value of the yield spread at the time of the breakout or alternatively where it was in the area you intend to trade on the future retracement vs the value of the spread by the time the price returns to test a key fibonacci retracement level — 38.2%, 50% or 61.8% — and where you might place your order/s. You could even fill the area with three separated buy/sell limit orders to average an entry of 50% if all orders get filled to guarantee at least partial fillings.

Having reached this point in the tutorial, let’s recap. Correlated instruments, especially bond yield spreads, tend to lead currency valuations. While it can add an edge to one’s overall strategy, it must be evaluated from a top-down analysis, taking into account other factors such as risk sentiment, market cycles, levels to trade from, fundamentals or trading time. The more convergence you can find, the better the odds you place for a trade to go in your direction. Even if it doesn’t, by never forgetting these 4 pillars, you should still keep your cool and let the statistics play out.

Resources To Access Bond Yield Spreads & Overlay Instruments

Tradingview: By now there is little doubt that tradingview has become the absolute dominant player when it comes to cloud-based charting tools for analysis. It allows you to draw anything on any chart, split your screen into many synced up charts, etc. While many features remain free as shown in the table below, the most advanced tools such as the calculation and overlay of any instrument, including bond yield spreads, you must sign up for either the PRO+ or the PREMIUM version. I recommend to start on a free 30-day trial and as the date of trial expiration comes close, you can take advantage of discounts up to 50% if you wait to convert as a client to the very last days.

You can compare the different plans available here.

Investing.com: If you prefer to skip the paid option tradingview offers, then this is your second best choice. The advantage of using investing.com charting tools is that is 100% free, however, it comes with a downside. Their charting tool won’t allow you to generate a bond yield spread or make any calculations for that matter. Instead, you will be limited to overlay various instruments in your chart, which in my opinion, I find it quite annoying as it’s visually less intuitive. To compare the differential between bond yields, one must pay attention to the slopes, which can easily lead, at times, to too much guessing and not as easy to follow as overlaying the actual spread in the chart.

Bloomberg Terminal/Reuters Eikon: For the most advanced traders that can afford the platforms, Bloomberg and Reuters charting tools offer exceptional features allowing the user to monitor all types of instruments. The downside here is the cost, which is probably quite steep for most retailers. The price of a Reuters or Bloomberg terminal comes around $1.8k/m.