Does the Equity Market Lead the Currency Market?

Market timing should be impossible

October 2021. Reading Time: 10 Minutes. Author: Kaushik Ganesan.

SUMMARY

  • Past equity market returns seem to predict currency returns
  • Such a currency timing strategy may be interesting as a diversifier
  • However, it is difficult to rationalize the results

INTRODUCTION

Bloomberg TV at 08:30 am EST: “The S&P 500 futures are trading lower as the US Dollar depreciated against G10 currencies overnight.”

CNBC at 9:45 am EST: “The USD appreciated given a strong opening in the S&P 500 due to better economic data.”

Stocks, bonds, currencies, and commodities are all interrelated and it is difficult to answer what variable is leading and which is lagging. Considering the starting and ending points of this complex multi-dimensional system of relationships is like asking, “Which came first, the chicken or egg?”.

However, despite this conundrum, financial analysts and journalists are constantly outlining feedback loops when discussing markets. In this research note, we will follow such a feedback loop and hypothesize that the performance of the equity market determines the direction of the currency market.

METHODOLOGY

Investing in currencies is like security selection in any other asset class and investment decisions can be based on discretionary or systematic signals. The largest trade is likely the carry trade, where currencies of countries with high interest rates are bought and ones from low-interest rate countries are shorted (read Don’t Get Carried Away by Carry).

Instead of using the interest rate to choose a currency pair, we are going to use the trailing 12-month equity market returns for each country to decide on the currency pair, i.e. use equity market momentum as a signal. If the difference between the 12-month equity return is positive, then buy the forward one-month contract of that currency pair, else short the currency pair. In-line with momentum research we ignore the most recent month of the last 12 months and rebalance the portfolio on a monthly basis.

We will refer to the strategy as the currency timing strategy.

EUR/USD PORTFOLIO