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Ever noticed how sometimes the fall of one market is explained by the rise of another? Have you ever wondered why?
No market evolves in isolation without affecting (or being affected by) another one.
Analysing interrelationships between various asset classes are called inter-market analysis. If you’re not familiar with this type of analysis, let me tell you a bit more about it.
As you probably know, there are different ways to analyze the markets. Namely, there are 3 – technical analysis, fundamental analysis, and sentiment analysis.
- Technical analysis only makes use of the price action, and various technical indicators to determine where prices might go next. This type of analysis is based on the assumption that prices tend to evolve within trends, that the past repeats itself, and that prices discount all available information as soon as it’s publically available.
- Fundamental analysis relies more on economic factors, figures, and statistics to determine the intrinsic value of an asset. Then, the investor makes a determination as to whether the asset is over or under-valued, and react accordingly.
- Sentiment analysis, as well as taking into account all available information, also analyses how the market participants themselves react to this information. It’s about deciding whether to trade in the direction of the market or against it and to know whether to go long or short on an asset. W
Inter-market analysis is sometimes considered a part of a fundamental analysis, as there are economical and fundamental relationships between markets. However, as inter-market analysis studies and interprets the price action of many assets, it’s more often classified as a branch of technical analysis.
The advantage of taking into account inter-market analysis is that it will help you broaden your outlook and take advantage of better trading opportunities. You will also be able to manage your positions more accurately and better mitigate risk. Moreover, you have an advantage over other traders that limit their analyses to only a single market.
So, let’s begin…
What is Inter-Market Correlation?
To know how one market evolves in comparison to another, you need to know how well correlated they are. The correlation coefficient describes the degree of this correlation.
The Correlation Coefficient
When markets evolve in the same direction, then they are positively correlated. Conversely, when they trend in opposite directions, then they are negatively correlated.
Correlation coefficients range between 1 (highly positively correlated) and -1 (highly negatively correlated), while a value of 0 indicates that there is no relation whatsoever between the analysed variables.
What are the major inter-market analysis principals?
- Bond prices and commodities are negatively correlated.
- Bond prices and stocks are positively correlated.
- Bond yields and stocks are negatively correlated.
- Bonds are positively correlated to stocks, but there is a lag between bond and stock prices, with bonds taking the lead and stocks following.
- Bond yields are negatively correlated to interest rates.
- When bonds are strong, while commodities are weak, then interest-rate sensitive sectors such as financials, utilities, and consumer staples outperform other sectors.
- When bonds are weak, while commodities are strong, then inflation-sensitive sectors and commodities stocks outperform other sectors.
- Commodities and the USD are negatively correlated – especially Gold & Oil.
- When the USD is strong, it penalizes large and exporting US companies.
- When the USD is weak, it favors small US companies.
Let see exactly how this works.
How Commodities, Bonds, and Stocks Evolve Depending on The Economic Cycle
When the economy is contracting, central banks usually implement loose monetary policies with the aim of stimulating the economy.
This typically means that bond prices are going down, and bond yields are going up. The stock market may also be going up, thanks to this loose monetary policy, but investors will be aware that the economy as a whole isn’t healthy, which can weigh down on overall investor sentiment and thereby negatively impact the stock market. In addition, demand for commodities will be in decline, which further weighs down on their prices.
When the economy starts to bottom out, the same usually happens to the stock market, as investors predict a bounce back in prices. Bonds and stocks are up, but commodities are still weak. The improving economic conditions prepare all markets for an economic expansion phase, which means that bonds, stocks, and commodities are heading up.
Inflationary pressures due to economic expansion might trigger a tightening of monetary policy. Interest rates can be raised, which weighs down on bond prices (with higher bond yields), while stocks and commodities are still rising.
Use Inter Market Analysis To Predict Assets Trend
When the economy peaks, stocks, and commodity investing may still be rising, but investors are starting to anticipate a contraction period, as the economy is growing at a slower pace. Stocks will soon form a top, followed by commodities, as investors start to anticipate lower demand.
Commodities and the US Dollar
As most commodities are priced in USD, any movement of the USD affects commodity prices. When the USD is weakening, buyers of other currencies can buy more commodities for the same price, which tends to increase demand for these commodities and increase their prices.
Of course, there are other, more fundamental factors influencing the demand for commodities. This further influences the degree of correlation between the USD and commodities.
Image 1: USD in the background and Oil in the foreground
Image 2: USD in the background and Gold in the foreground
Gold Vs AUD/USD
Australia is one of the largest exporters of gold and other precious metals in the world. Therefore, when the price of gold goes up, this then supports the price of the Australian currency. As can be seen below, there is a positive correlation between the 2 assets.
Image 3: AUD/USD in the background and Gold in the foreground
Oil Vs USD/CAD
Canada is a big oil exporter, and most of its exports go to the US. The USD/CAD currency pair moves in large part because of the American consumption of oil, and how they react to changes in oil prices.
If American demand for oil increases, then prices will rise, and the USD/CAD will consequently decrease. On the other hand, when US demand falls, then oil prices can tumble and hurt demand for the CAD as a whole.
Image 4: Oil in the background and USD/CAD in the foreground
Bond Yields And The Currency Market
Monetary policy decisions have the biggest impact on the Forex market, and also strongly affect the bond market. Bond yields can rise or fall depending on investor views on future interest rates decisions, or because of market volatility and uncertainty.
When market participants are worried about the economy, or when the stock markets are very volatile and there is a lot of uncertainty, they tend to remove their money from the stock market to invest it in the bond market, which is considered to be more secure. This “flight-to-quality” increases bond demand, which in turn pushes their prices higher and their yields down.
When central banks decide to tighten their monetary policy by increasing their interest rates (as it happens now in the US), the currency of these countries increases. Bond yields also go up, which usually hurt the stock market because of stronger inflationary pressures that can affect the purchasing power of the currency. The stock market will also go down because of portfolio reallocation, as bonds become more and more profitable.
Bond yields and the FX market usually evolve in the same direction, while bond yields and the stock market have a negative correlation. Forex traders can also use bond spreads in their currency carry trade strategy. This method is used to borrow money in a currency with low-interest rates to invest it in a currency with higher interest rates, making profits on the difference between the 2 interest rates.
Image 5: USD Index in the background and 10 Year T Note in the foreground.
What’s the Bottom Line?
Of course, these relationships shift and disappear for a while, but they are always there in some way. This is especially true when the inflation environment evolves, which triggers asset allocation adjustment. Rotation is useful to link current business cycle stages with current strong and weak asset classes; so then you can take advantage of it by investing in the most promising one.
For instance, disinflation – a lower rate of inflation – will have a negative impact on commodities. On the other hand, it’s generally positive for the stock and bond markets.
Inter-market analysis is also useful in diversifying your investment portfolio to target better returns with lower risks associated. To conclude, inter-market analysis is a valuable tool, especially for mid to long-term investing.