Have you ever thought on a technique that would allow you to further decode the intrinsic valuation that would exist when trading an instrument such as the USD/MXN? Earlier this week, in our lively discord room, our user @alex asked me: HI Ivan, what correlating markets would you use for a pair with Mexican peso?
Alex knows well by now that as part of crafting my views on a particular currency pair, I always resort to the analysis of intermarket flows in order to understand how much value exists when the time comes to consider a position at certain key levels.
Let’s dive into my response to @alex, as I believe each and every one of you can find benefit in discretionarily adopting this type of approach in order to consolidate one’s view on an entry, hold a position for a longer run or perhaps decide to be more cautious by taking partial profits.
It’s important that any analysis of intermarket flows is relatively simplified, in other words, you don’t want to be meddling your charts with an excessive number of overlapping lines that may obscure your judgment by falling into the trap of analysis paralysis. Similarly, you better stay away from factors that will limit the ability for you to perform the proper backtesting of certain assumptions.
What I mean by that is to not get caught up in the daily noise of reporters (not traders), who are experts in trying to justify via fundamental-oriented explanations, the performance of a particular currency in hindsight. While fundamentals are key inteal factors that influence a currency’s appeal, it becomes really hard to conduct proper backtesting that helps to quantify a strategy’s improved refinement if one has to account for all these nuances affecting a currency.
First and foremost, for the purpose of filtering out the wheat from the chaff, it’s important that as traders, we identify the financial instrument with the highest historical correlation to USD/MXN in order to build the hypothesis that will serve as the coerstone of our analysis.
We know that the Mexican Peso falls under the category of what’s referred to as an exotic currency, hence it would be influenced by the ebbs and flows seen in emerging markets. We also should understand that as part of the performance in EM currencies, due to the size of its economy, none has a bigger influence in the overall sentiment of this conglomerate than the Chinese Yuan.
At the same time, we cannot ignore that the valuation in the US Dollar versus the Chinese Yuan (offshore) acts as a barometer to measure either a positive resolution in the trade war between the US and China or a more protracted standoff by way of capital in or out of the Chinese Yuan market.
We could also draw parallels, even if limitations exist due to the idiosyncrasies of each country, that the lay of the land in the US-China trade war can act as a proxy to anticipate a further escalation in trade issues between the US and Mexico. Also, not to be forgotten is the fact that any EM economy will rely on the global growth outlook to keep attracting flows, and as of today, there isn’t a greater influencing factor to determine prospects for the global economy to stay afloat than China.
With all the above shared, let’s look at the first hypothesis. How correlated does the USD/MXN get to be against a pair the likes of the USD/CNH? By applying a 20-period correlation coefficient, one can observe that the connection between the two assets is clear. I’ve drawn a horizontal line by simply eye-balling what’s been the average correlation during 2019, and at roughly 50%, is da good.
As a rule of thumb, when running a hypothesis in a particular correlation, if it doesn’t fall below the 0 mark or the episodes when it does are very limited, it basically translates into a market that perceives way too much disconnect between the primary and the secondary instrument to allow the divergence in intermarket flows to extend beyond a certain period of time.
Another market that has proven to have a historically high correlation with the USD/MXN is the US Dollar index in order to measure the overall buy flows into the world’s reserve currency. As the chart below exhibits, other than the bleep lower in correlation in the last month, the DXY is a must instrument to monitor.
So, at this stage, we’ve identified two instruments highly correlated, by historical standards, to the USD/MXN. Next is the phase to simplify our job as traders. This means we have the choice of singling out each correlation to determine the fair value of USD/MXN, or to simplify the process by analyzing the USD/MXN valuation via the combined formula TVC:DXY/96+FX:USDCNH/6.75 *
*Note, the values in the denominator must be updated on a regular basis.
The trick that I perform to stick with only one combined formula as my value line is to assess whether or not the new correlation coefficient improves when I account for both assets under one formula. If the gaps below the 50 line are reduced, that’s a good indication that the combined formula improves the reliability to act as our default intermarket value line to assess opportunities.
In the USD/MXN, it’s a close call as it gives us a stronger correlation through earlier in the year, while it widens the divergence towards the end of the study. When that’s the case, feel free to account for an extra amount of data to conclude which value line to stick with. My preference is to pair them up.
Once our decision has been made, next is to declutter the chart by just keeping the value line that will partially or fully dictate our bias. You have the ultimate say if the value line is going to act as your primary signal or instead you just want it as a confirmation of your main bias, which could be based on the technical analysis of the chart using a moving average, indicators, etc.
Regardless, what I will explain next, should serve as further proof that by just adding the value line, we can obtain some excellent buy or sell side entries if enough discretion is applied. What I mean by discretion is to only engage in areas that have proven to be support or resistance, hence you’d decide to enter on a trade if the area is retested and divergence on the value line is observed.
Since the start of 2019, in a blue horizontal line, I’ve identified these areas of support or resistance where the market reacted from. Once a retest of the area occurs (highlighted by a vertical line), ask yourself if a divergence with the value line is present from the first time the area was formed. That’s what I’ve highlighted in purple arrows in the chart below. If so, this is a communication that the risk is for the pair to fade the breakout as intermarket flows are not supporting the overall bias.
We can clearly see from the illustration above that this simple strategy of fading breakouts if the intermarket flows don’t agree yielded great results. You cannot make this stuff up. Out of 9 trades that would have been entered, with the exception of trade 4, which overshot the resistance and may have led to a potential loss, the rest of retests were clear failures which should have provided as pristine an area to enter a trade at a discount as it gets. It’s then your job to decide how best you will risk managing the position to extract the most pips out of each trade campaign.
This is a process that is repeatable in any market, with the caveat of correctly understanding what ticks your markets. If you’d like to find out more about intermarket analysis to complement the analysis of your forex charts, feel free to reach out to me via our discord room or twitter. @Alex got his question answered, so will yours if you reach out. I am here to help you improve and on a mission to pass on my knowledge with no fillers, and no-nonsense.