What every trader should understand about the link between currencies and stocks

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Increasingly the global economy is becoming more integrated.

Companies operate and transact across multiple jurisdictions and continents, goods and services flow freely across borders unfettered by all but the odd customs check as tariffs have been reduced, quotas scrapped, and trade restrictions dropped as free trade agreements have become increasingly popular.

That’s meant that the policy levers that central banks and governments have at their disposal to protect their local industries and their domestic economy are reduced. Sure, they can lower interest rates to stimulate their domestic economy but as rates across many nations have converged to zero even this lever has become redundant, at least at the margins for a central bank’s domestic economy.

But there is one more very important lever – probably the biggest – and certainly the most important transfer price in any economy and across the globe. That is, central banks and sometimes governments can use their currencies to achieve a competitive advantage over other nations and industries in those countries that even the most aggressive cost-cutting measure would struggle to achieve.

They can let their currency fall, or as is sometimes the case let the currency rise, to balance out economic growth. Lower currency means more competitive exports, while a higher currency effectively shifts economic growth offshore, taking the heat out of the local economy.

That’s the secret of Australia’s 23 years of uninterrupted economic growth. The RBA has allowed the Aussie dollar to float freely in a range between 0.4775 and 1.1080 as the economy has needed it. It is weak when the economy needs a boost, but became strong when the mining boom threatened an inflation breakout and an overheated economy.

Currencies matter.

And they matter for traders too.

Take the relationship between the Nikkei and the relative values of the US Dollar and the Yen (or USDJPY) since Abenomics was first announced. The Nikkei surged even when Abe was just the opposition leader because Nikkei traders recognised that Abe was going to drive the Yen much weaker against the US dollar and other currencies. That makes Japanese industry and Japanese companies more competitive.

Add in a dash of Bank of Japan quantitative easing and you have the recipe for improved economic growth and stock prices.

Indeed by debasing the Yen – which fell from below 80 against the USD dollar to 122 recently (higher USDJPY means a weaker Yen) the government was also able to arrest falling inflation and help growth overall, which in turn feeds back into a stronger Nikkei.

Having seen the success of Abenomics and with the Eurozone economy struggling to recover from the ravages of the GFC economic downturn the ECB decided to undertake its own version of Quantitative Easing. That sent the Euro into a tailspin and the DAX, and the other big continental European bourse, into a raging bull run as the Euro crashed from 125 last December to 1.05 a couple of months ago.

Already it seems Europe is reaping the benefits. Perhaps ECB QE was unnecessary, and came too late.

Closer to home the relationship between the ASX and the Aussie dollar is not as strong. But even here there is a clear directional relationship between the falling Aussie and a rising stock market. It’s not a lock step relationship, but part of RBA Governor Glenn Stevens’ desire for a lower Aussie dollar is he knows with a lower currency the economy will receive a boost to economic growth over a 1-2 year time horizon.

This of course feeds back into company performance, both through a transition to domestic consumption (instead of offshore purchases), and it also makes companies which receive income offshore – usually in US dollars – more competitive because the US dollars are worth more Aussie when they are repatriated. That’s good for the company and good for the federal government’s tax receipts.

You’ve probably heard the term ‘currency wars’ more than once in recent years. And you’ll also have noticed how stock markets around the world have been rallying. The two are not unrelated. As you’re watching the flows in markets day to day, it’s always worth checking in to see what the currency has done too.

SEE ALSO: What every trader needs to understand in the new era of volatility

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