Using Forex Market Correlations as a Leading Indicator

True or false, all technical indicators are lagging?

The answer – mostly true. It all depends on how you define the term, “technical indicator”. If you are thinking of indicators such as moving averages, MACD or RSI, then yes, these are all lagging indicators as they are based on past price action.

But what if I told you that in certain market conditions, there is such a thing as a leading indicator. While it may not get labeled as a conventional technical indicator, it certainly is an indicator in the true sense of the word.

This is not an indicator that will tell you when to buy or sell or even when to take profit. Instead, think of it as a strong hint on when to be bullish or bearish on a particular basket of currencies.

Which basket, exactly? The Japanese yen crosses.

In this lesson, we will discuss a very simple way to formulate a bullish or bearish bias for the yen crosses which in turn will help you time your entries and take advantage of opportunities with huge potential.

We will define the terms “risk on” and “risk off” and also look at how this change in sentiment impacts the yen crosses and how you can capitalize on it.

The yen crosses are the basket of currency pairs where the major currencies are traded against the Japanese yen (JPY).

Those currency pairs are as follows:

• USDJPY
• EURJPY
• GBPJPY
• AUDJPY
• NZDJPY
• CADJPY

There are two major characteristics that you need to know before attempting to trade any one of these crosses.

Volatility is all but guaranteed

If you trade any of the pairs listed above one thing is for certain, you will experience more volatility than you might in other currency pairs such as EURUSD or GBPUSD. This is especially true during periods with lower levels of liquidity such as major bank holidays or the summer months for the US market.

This volatility is especially noticeable in times of great concern or even outright fear, as it was during the 2008 global crisis. The yen crosses were some of the more active currency pairs during that period as market participants moved their capital out of riskier assets and into safer bets such as the Japanese yen.

Measure of risk appetite

This odd-sounding term is actually quite straightforward. It refers to the amount of risk, or potential for an adverse impact on trading, that investors are willing to accept. The level of this appetite is sometimes referred to as risk sentiment, a gauge of how risk-hungry investors are at any given moment.

The riskier assets that are attractive when risk appetite is high are higher yielding, such as the Australian dollar, British pound, equities and even some commodities. Although these assets can produce a higher return on investment, they do carry a greater amount of risk.

Alternatively, lower yielding assets such as the Japanese yen are considered less risky. So when investors begin moving their capital into something like the yen we say that the risk appetite for market participants is low. In other words, based on market conditions, they are unwilling to accept a higher level of risk and therefore seek safer assets in which to invest.

This is why market participants refer to the yen as a safe-haven currency. The currency is in demand when participants want to limit their exposure to losses in the event of market downturns.

This idea of being able to gauge how much risk investors are willing to accept is key to understanding the following concept.

No, this has nothing to do with “wax on, wax off”, and even Mr. Miyagi will need help understanding this one.

I know, I know…bad joke. If you don’t understand the above reference you are probably better for it.

In the same way that risk appetite refers to the level of risk investors are willing to accept, risk on and risk off refer to the overall “mood” of the market.

For example, if you hear “risk on” in reference to market sentiment, it means that risk appetite is healthy and market participants are therefore willing to accept greater amounts of risk in return for the potential for higher gains.

On the flip side, the term “risk off” refers to market conditions in which risk appetite is low and market participants are therefore unwilling to accept greater amounts of risk in return for the potential for higher gains.

Instead, these participants opt for safer, lower yielding assets such as the Japanese yen. This movement to safer assets is often referred to as a “flight to safety”.

It’s important that you understand this before moving on, so be sure to ask any questions in the comments section below.

So how does all of this translate into Forex market correlations as a leading indicator and give us a trading edge?

For the answer, we turn to a macro view of how the yen crosses behave in these risk on and risk off environments. By “macro” I’m referring to the larger movements these pairs make, specifically the key technical breaks of major levels.

As you now know, the yen is considered a safe-haven currency that is highly sought after when panic or all out fear erupts in the markets. And because we have six options when it comes to trading the yen crosses and they rarely all break at the same time, we can use them as leading indicators. More on this later.

Below is a chart to illustrate how these crosses reflect a higher degree of correlation as the level of fear in the market increases.

Notice in the chart above, the degree of correlation between these currency pairs increases as the level of fear increases. This makes sense as each major currency is tied to the Japanese yen, which in turn is tied to risk sentiment or the level of fear in the markets.

One of the best barometers for this is USDJPY due to the pair’s unique relationship to both safe-haven currencies in the US dollar and Japanese yen. But in order to really get a feel for the level of fear in the markets we need to view all six yen crosses on a macro level.

What does this mean?

It means we need to view each one on the daily time frame or higher in order to focus on the most significant levels in the market. This could mean viewing the last six months of price action or even the last few years.

Let’s take the recent break on NZDJPY as an example. We could call this the first domino to fall, so to speak, in a market that was quickly moving toward a risk-off theme.

The NZDJPY weekly chart above shows a head and shoulders pattern that formed over the course of sixteen months. The pattern confirmed in June of this year and has since met its 1,050 pip measured objective in fairly short order as demand for the yen has increased substantially in recent weeks.

Here’s where the idea of using such a break as a leading indicator comes into play. Shortly after NZDJPY made its break, three weeks to be exact, AUDJPY stole the spotlight when the pair broke six-year channel support.

Here is a look at the AUDJPY weekly chart. The support level dates back more than six years to when the pair broke out.

Coincidence?

Perhaps. But let’s move on to see if we can find any other yen crosses that made similar breaks following the confirmation of NZDJPY’s weekly head and shoulders pattern.

The next two currency pairs we’re going to look at are USDJPY and CADJPY. Let’s start with USDJPY first.

Almost two months after AUDJPY’s break of weekly channel support, USDJPY fell below a key trend line off of the year low. While this break was not as significant as that of AUDJPY or NZDJPY, a break of a trend line that is this well-defined and based on a yearly low was significant enough to catch our attention.

Note how the pair broke through this level with conviction. Again, this break occurred nearly two months after AUDJPY broke to the downside and almost three months following NZDJPY’s reversal.

What do you think? Still a chance that all of this is just coincidence?

If so, lucky for me I still have three more yen crosses with which to prove this concept of using risk sentiment as a leading indicator.

Next up is CADJPY. Similar to NZDJPY, the pair had formed a broad head and shoulders pattern on the weekly chart. This particular pattern formed for three and a half years before confirming.

While this is not the best-looking reversal pattern, it does meet the criteria for a head and shoulders reversal. While the formation of the pattern can be argued, one thing that cannot be understated is the significance of the recent break below the 92.00 area.

Now for the holdouts, EURJPY and GBPJPY. I’m going to start with EURJPY as this is a favorite of mine lately.

Why is it a favorite of mine?

There are actually three very good reasons with the most significant and telling reason being this idea of a higher correlation between the yen crosses in times of increased volatility and fear.

Without further ado, here they are:

1. Previous breaks on NZDJPY, AUDJPY, USDJPY and CADJPY indicated that market participants were losing their appetite for riskier assets and thus buying the Japanese yen
2. Failure to hold above the key horizontal level shown below
3. False break to the upside of this wedge pattern, which often indicates a reversal is in order

The most notable of the three reasons listed above is the fact that the four other crosses had already broken to the downside with conviction. In fact NZDJPY and AUDJPY both catalyzed weeks before EURJPY began sliding lower.

This alone gives credence to the idea that multiple breaks on the yen crosses in a risk off environment can be used as a leading indicator for other crosses that have not yet experienced any significant movement.

One thing I do want to point out is that while NZDJPY and AUDJPY were breaking to the downside, EURJPY was holding firm. In fact the pair was rallying for most of that period.

Because the pair was actually appreciating as the risk off theme began to take hold, the opportunity for a short position in EURJPY was greater than that of a pair like NZDJPY or AUDJPY, both of which had already sold off substantially.

This was the main reason for my commentary titled, EURJPY: The Last Domino to Fall?.

I had good reason to believe that with the other yen crosses selling off with conviction, EURJPY was likely to follow in their footsteps. Remember, as volatility increases and fear takes over these yen crosses begin to establish a higher correlation than they would otherwise have in more of a risk on environment.

Like everything in the Forex market, these patterns of risk on and risk off can change over time. So while the Japanese yen is one of the favored safe-haven currencies now and has been for some time, this may not always be the case.

That said, everything is constant until it isn’t. So as long as the yen continues to exhibit the behavior of a safe-haven currency we should continue to trade it as such.

Another factor that is constantly changing is the level of fear in the markets. As we all know, no two days are exactly the same. Today’s mood might be completely different from yesterday just as tomorrow’s mood could be vastly different from today’s.

The price action we see on our charts is driven by psychology in one way or another. And because each day is unique and no two individuals are the same, the level of fear exhibited from one day to the next is in a constant state of flux.

So while the moves in the charts above may appear as though they formed within a 24 hour period, the reality is quite the opposite. The psychology and fear that ultimately catalyzed those moves had built up for several weeks and months and only materialized once fear reached a level that could no longer be ignored by the masses.

This means that there are varying levels of fear and thus, varying degrees of risk on or risk off as a market theme. With this in mind, it becomes all the more necessary to remain patient and time your entries accordingly.

Just because one yen cross begins to appreciate or depreciate does not mean that the others will quickly follow suit. While they do share certain characteristics in times of increased volatility and fear, one or two crosses selling off is not an excuse to ignore the rules we have developed as price action traders.

The full impact of risk on and risk off as a market driver takes months to materialize. There are varying degrees of fear along the way that will either feed a risk-off theme or neutralize it. However, no one instance is enough to throw a market into a full-blown panic. It’s always a slow buildup regardless of how it may appear on the surface.

Remember that the safe-haven status of the Japanese yen is susceptible to change, as all things are in the Forex market. However, as long as the currency holds true to that status and continues to perform well during times of fear we should trade it as such.

Use the correlations discussed here in the same way a painter uses a broad brush to paint the background of a mural. It helps to quickly fill in the large gaps and highlight the focal point, but the details of the mural still need to be filled in using a much smaller, more detail-oriented brush.

As price action traders, our smaller brush is the use of key levels and price action strategies that allow us to turn market opportunities into profits while themes such as risk on or risk off help us to formulate a directional bias.

Did you find this lesson helpful? What do you think about using the correlation between the yen crosses as a leading indicator?

Let me hear your thoughts. Leave your comment or question below and I will answer it personally.