November 2nd, 2013
Part 1b of a series on the basics of inter-market analysis:
A short primer on what it is, why it works and how to profit from it.
Continued from Part A.
by Cliff Wachtel, FX Empire
Direct Inter-Market Relationships
Some markets have a clear direct influence on others. For example as noted above:
Oil And Stock Indexes: Although crude oil is a risk asset that usually tracks or follows stock indexes, if oil prices suddenly spike (typically from supply concerns due to Mideast tensions) they can send most risk assets lower because demand for oil is inelastic in the short term and cuts earnings and growth.
Credit Markets And Currencies: As we discuss in some detail here, one of the most influential drivers of a given currency's price and trend is:
- Its central bank's benchmark rate and related bond rates, relative to those the other major currencies. The higher its benchmark interbank and bond rates, the stronger the currency's uptrend versus those currencies.
- Similarly, any data that changes expectations about the direction, timing, or size of increases of decreases in these benchmark and related bond rates.
Some Asset Markets Have Direct And Indirect Relationships
In addition to being influenced by the same global market moving events or economic trends, some asset classes act directly on others.
- EUR and USD: These two currencies move have a strong negative correlation powered by both indirect and direct factors:
- Indirect: Out of 8 major currencies the EUR has the fourth highest benchmark interest rates, a fragile EU economy desperate for any good news makes the EUR a clear risk currency that moves up with optimism.
- Direct: These are by far the two most widely traded currencies, so when markets are buying one, they tend to be funding those purchases via sales of the other. Thus they tend to move like two children on a seesaw, one up, one down.
See here for more on how the major currencies rank and why.
These Relationships Can Change In Both Short And Long Term
Oil and stocks: as noted above, oil normally follows stocks, a temporary sudden spike in oil prices due to supply fears (typically due to Mideast turmoil) means rising oil prices pushing stocks lower. In other words, oil changes from being a risk asset that follows stock indexes into a safe haven asset that drives stock indexes in the OPPOSITE direction, with oil prices rising on oil supply fears and stocks falling.
The USD and stocks: The USD has usually been a safe haven asset in recent years, while stocks or stock indexes are risk assets, and so they've tended to move in opposite directions. However as we discuss here, like any currency, the USD is strongly influenced by expectations about the future direction of benchmark USD bank and bond rates. The Fed has said it will not raise rates until there are certain improvements in US economic data. Thus when markets see that data improving, or expect it to improve, not only do stocks rise as they normally do with good data, so does the USD. That rise in the USD isn't because the USD has become a risk asset, but rather because that same data or news is improving expectations for the pace and size of interest rate increases.
Ok, So How Do I Use Actually Use Inter-Market Analysis?
Note that this is just an introductory article to a huge topic that can fill volumes, and that specifics vary depending on your specific market of interest. That said, here are some generally applicable guidelines.
Understand what really drives your asset of interest/Know your market movers: It isn't enough to just know if it's a risk or safety asset. For example as noted above, the USD may generally behave as a safety asset, but more fundamentally it moves with US interest rates and expectations about their future direction. Indeed, as we discuss here, interest rates and expectations about them are prime determinants of whether a given currency is a risk or safe haven asset.
Find good barometers of those factors that move your market: For example:
- For monitoring risk sentiment, a major stock index like the S&P 500 tends to be as good an overall risk appetite barometer as any. It's got the largest stock index by market capitalization, and thus by nature shows how a wide range of sectors and regions are feeling. If you trade during hours when US markets are closed, use one of the largest indexes that are open during the session you trade, be it Asia or Europe. See here for more on how and why forex traders need to monitor stock indexes. However as we discuss here, your choice of stock index will vary depending on your estimated holding period, time frame, and depending on those, the hours during which you trade.
- Income investors need to pay extra attention to interest rate trends for the currency in which their investments are denominated, because both bonds and dividend stocks are highly interest rate sensitive.
- Commodity prices are more influenced by specific supply and demand considerations. Indeed unlike stocks and currencies, commodities tend to behave like risk assets only to the extent that risk appetite or optimism influences supply. Thus commodities for which demand varies most with economic conditions (like copper or iron) tend to be more sensitive to changes in risk sentiment.
Want To Know More?
Inter-market analysis is a huge topic, so this series is just to provide an overview so that you're better able to pursue more in-depth study on your own. See the next two parts of this series:
For more in-depth coverage of this topic, and all topics covered in this series on inter-market analysis, see The Sensible Guide To Forex: Safer, Smarter Ways to Survive and Prosper from the Start (Wiley 2012).
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DISCLOSURE/DISCLAIMER: The above is for informational purposes only and not intended to be specific trading advice. In other words if somehow you lose money based on the above I take no moral or legal responsibility for it. Deal with it.