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Currencies can move for a variety of reasons. Sometimes they are moved by macroeconomics or market sentiment.
At other times they are moved by other asset classes.
Traders can be blind-sided by unexpected moves in the Forex markets. These moves are often caused by other asset classes.
The three biggest Intermarket influences on the FX market are namely:
- Fixed Income, also known as bond markets
- Equities, also known as stock markets
- Commodities, also known as tangible assets
Some of these asset classes move in tandem. While some of them move inversely to each other. Sometimes they move without any correlation at all.
If we want to succeed as traders, we need an edge in the market. Understanding how asset classes affect currencies can give us an edge in our trading.
In this article we will discuss the following concepts:
- Intermarket analysis and economic cycles
- Bonds and bond yields
- Equities (Stocks)
- The most common Intermarket correlations
- Intermarket correlations are not perfect
- The right approach to Intermarket analysis
Intermarket Analysis And Economic Cycles
Economies do not move in straight lines. They go through different economic cycles.
The most common stages of these cycles are expansion, peak, contraction and recession.
Every business cycle will have different inflation and interest rate characteristics. Asset classes are normally driven by changes in interest rates and inflation.
Traders need to keep the business cycle in mind when doing Intermarket analysis. Correlations between asset classes can differ in various business cycles.
What Are Bonds?
Bonds can be described as loans. They are a “form of financing or borrowing for countries and big corporations”.
Governments and big corporations require vast sums of money to function properly. How do they raise money when they require funds?
The funds they require are too much for normal banks to provide.
They split the amount they require into smaller chunks called bonds. The bonds are sold on the primary market.
The government or corporation offering the bond is called the issuer. Buying a bond is like providing the issuer with a loan.
The amount a bond is purchased for is called the face value.
In return, the issuer agrees to pay back the face value at an agreed time. This agreed date is known as the maturity date.
Some examples of government bonds
There are various bonds which comes with different maturity dates. In the US there are three types of government bonds namely:
- Bills (maturity dates of less than 1 year)
- Notes (maturity dates between 1 and 10 years)
- Bonds (maturity dates of more than 10 years)
Bonds might be called differently is different countries.
What incentive is there for investors to buy bonds? The issuer also agrees to pay the investor interest on bonds.
This interest payment is called the coupon. Let us see how this works in the example below.
The coupon rate will differ from country to country. It will also differ based on the length of the maturity date.
The riskier the bond the higher the coupon rate will be.
Bonds from junk status economies need to pay higher coupon rates. This is because investors need an incentive to risk a possible default.
The length of maturity also plays a role in a fair coupon rate. The uncertainty of longer-term interest rates must offer a higher reward.
That’s why 30-year bonds normally offer higher returns versus 3-month bonds.
What Are Bond Yields?
An important thing to know is that bond prices are not fixed. The moment bonds trade in the secondary market their prices can fluctuate.
This brings us to bond yields. Bond yields are calculated by dividing the coupon rate with the price of the bond.
This means when bond prices go up, the yield will go down. When bond prices fall, the yield will go up.
A bond’s yield is the rate of return “based on the actual market value of the bond”.
What Moves The Bond Market?
Interest rates are one of the biggest factors that affect bond prices. When interest rates rise or fall it affects the potential yield of a bond.
The example above illustrates the effect of interest rates on bond prices.
Bond prices move inversely to interest rates. Rising interest rates cause the prices of older bonds to fall.
The falling prices allow the yields of older bonds to rise to compete with newer issued bonds.
The opposite is also true. When interest rates fall, the prices of bonds increase.
Falling interest rates mean newer bonds will have lower coupon rates. Older bond prices can increase to match the lower yields of newer bonds.
Interest rates play a massive role in Bond markets. Inflation is one of the main drivers for interest rates.
This means inflation expectations can also drive bond prices. When there are signs of inflationary pressures bond yields normally go up.
The opposite of this is also true.
Uncertainty is also another driver of bond prices. This occurs when equity market performance is expected to drop.
Bonds are considered one of the safest investments. When investors think equities will fall, they run to safer investments like bonds.
This drives up bond prices which in turn drives down bond yields.
The opposite of this is also true.
Bonds And Currencies
Why should forex traders care about the bond market? Both currencies and bonds have strong dependencies on interest rate fluctuations.
Bond markets can have very close relationships with their respective currencies. This is because both move with interest rates.
Bond yields and currencies appreciate when interest rates are expected to climb. Moves in bond yields are often followed by similar moves in the local currency.
Above is an example of the US 10-year treasury yield and the Dollar Index. Notice how the moves between the two are largely correlated.
This effect can also be seen by pairing the bond yields of two economies together. The difference between the bond yields of two countries is called the yield spread.
The country which offers a higher yield on their bonds is more attractive to investors.
Below is an example of the USDCAD and the 10-year bond yield spread for both currencies. Did you notice how the USDCAD pair followed the yield spread?
This is because capital flows favour countries with higher yields. The dollar appreciated against the CAD due to the US having higher bond yields.
The chart above illustrates the correlation between currency pairs and corresponding yield spreads.
The bottom line is that economies with higher bond yields attract more investments.
This creates demand for that economy’s local currency. Lower returns on bonds normally lead to a weaker currency.
Rising bond yields are not always a good thing
It’s important to realize that bond yields and currencies do not always move in tandem. There are circumstances when higher yields can cause a currency to devalue.
We learnt that riskier bonds need to pay higher yields to attract investors. This means yields will rise when there is increased risk of a country defaulting on its debt.
When this happens, the relevant currency should depreciate even though yields are rising.
An example of this is the rapid rise of Italian 10-year bond yields in 2018.
Notice how the sudden spikes in Italian bonds yields caused depreciation in the Euro.
This would have provided Forex Traders with a great edge in the markets. Every time Italian bond yields spiked could have been opportunities to sell the Euro.
There are also other examples of how yields can assist Forex Traders. The yield spread between 10-year German and Italian bond yields is an example.
Some analysts use German and Italian 10-year yields as a sentiment gauge for the Euro.
Whenever the yield spread rises it shows Euro risk increasing. When the yield difference decreases it shows Euro risk decreasing.
This means watching the 10-year German-Italian yield spread can offer Forex trading opportunities.
Notice how the Euro index followed the yield spread lower. As the spread grew larger the Euro depreciated.
This could have provided sentiment-based trades using the Euro.
What Are Equities?
Equities are stocks and shares of companies. Buying equities means that an investor is buying partial ownership of a company.
Once a share has been sold in the primary market it can be traded freely in the secondary market.
The price for which equities are sold in the market is called the market price. This price may be different from the fair value price.
The fair value is the estimated true worth of a stock or share. What a stock or share is selling for may differ from what the market thinks its worth.
Equities are considered a riskier asset versus something like government bonds. As such equities require a higher return to compete with bonds.
When deciding between bonds and equities investors use the Equity Risk Premium (ERP). The ERP is the difference in return between stocks and bonds.
Difference between Stocks and Stock Indexes
There is an important difference between stocks and stock indices or indexes. An index is stocks or shares that are grouped together.
One of the most popular examples is the S&P 500. The S&P 500 is an index that consists of the 500 biggest large-cap companies in the US.
What does it mean when you buy and sell an index like the S&P 500? It means you’re buying and selling shares in all 500 of the companies in the index.
There are indexes for all major companies in each country. Some of the most popular indexes in the world are:
- S&P 500 (index includes 500 leading US companies on the NY stock exchange)
- FTSE 100 (index of 100 leading UK companies on the London stock exchange)
- CAC 40 (index of 40 leading companies listed on the Paris stock exchange)
- DAX 30 (index of 30 selected German blue-chip stocks
- NIKKEI 225 (index of 225 top Japanese companies on the Tokyo Stock Exchange)
Economic Influences On The Equity Market
The main driver for Equities is the economy and future economic expectations.
In a growing and expanding economy companies do well. They sell more goods and services which means they make more profits.
When company profits increases, their stock values normally increase as well. That causes stocks and shares (equities) to rise.
Above is an example of the correlation between equities and economic performance. The two periods are correlated with the 2000-2003 and 2007-2009 recessions in the US.
Share prices are cyclical. This means they perform well during expansion and perform badly during recessions.
Interest Rate Influences On The Equities Market
The effect of interest rates on equities is extremely important.
An important correlation is the inverse relationship between stocks and interest rates.
This means when interest rates rise, stock prices normally fall. When interest rates fall, stock prices normally rise.
Notice how the S&P500 downturn was preceded by interest rate hike cycles. The moment when the economy went into recession the FED stepped in to lower interest rates.
The moment interest rates were low enough the economy turned back, and S&P started climbing.
There is a good reason for this inverse relationship. When interest rates rise, it makes borrowing costs more expensive.
Borrowing costs will affect companies in several ways.
During these times investors sell their risky equities in search of safer returns. This causes investors to buy bonds which causes bond prices to rise.
The opposite of this is also true. Lower interest rates boost growth and expansion.
This causes more demand for goods and services. Companies sell more goods and services and increase their profits.
During these times investors would sell their lower return bonds to buy stocks.
Investors prefer equities during expansionary cycles as stocks offer higher returns than bonds. During recessions, they prefer less risky assets like bonds.
That is why some investors say there is a time to own either equities or bonds.
Inflation Is Another Important Influence On Stocks
Sometimes the correlations in asset classes do not work as expected. This is often referred to as “decoupling”.
Decoupling is when the normal correlation between asset classes breaks down. One of the biggest reasons for decoupling is inflation.
The way asset classes relate to each other is dependent on inflation.
Stocks and bond prices normally move together in an inflationary market cycle. As inflation picks up it spurs higher interest rate expectations.
This leads to higher bond yields. The higher bond yields send bond prices lower.
The rising return on safer bonds makes stocks less attractive. This causes stock prices to fall.
During deflationary cycles, stocks and bonds can decouple.
An example of this was during the Asian collapse in 1997. Deflation pushed down stock prices but sent bond prices higher.
During deflation, stocks fall due to decelerating growth. Bond prices rise due to falling interest rate expectations.
Interest rates and inflation can cause bonds and stocks to move in tandem or to move inversely.
Equities And Currencies
The relationship between equities and currencies can be tricky. A lot of this has to do with exports.
International companies rely on exports to grow and expand. Exports are dependent on currency values.
When a currency is weak exports are cheaper abroad. This boost growth of exporting companies which increases earnings and stock prices.
When a currency is strong, exports are expensive abroad. This causes less growth and reduced exports.
Which leads to a decrease in export company profits and a fall in stock prices.
The Most Common Intermarket Correlation
The market is made up of people. People are susceptible to emotions.
Emotions often result in one of the most common Intermarket correlations. It is called risk-on and risk-off sentiment.
It boils down to whether traders feel optimistic or uncertain about the future.
When news or events occur that creates uncertainty traders get worried. This causes them to move their investments from risky to safer assets.
This is called risk-off sentiment. Equities are considered as a risky asset. This means investors move out of stocks during these times.
These moves are explained as “safety precautions” by investors to protect their capital. Investors prefer safe-haven assets during risk-off sentiment.
Safe-haven assets keep or increase in value “in times of great market turbulence”.
Below is a list of the most common safe-haven assets:
- Longer maturity government bonds
- Japanese Yen and Swiss Franc
When news or events occur that create optimism traders want to take on risk. This causes investors to move capital from safer to riskier assets.
This is called risk-on sentiment. During risk-on sentiment investors feel confident and look for higher-yielding assets.
Below is a list of the most common assets that appreciate during risk-on sentiment:
- Higher-yielding currencies (AUD, NZD and CAD)
Risk Sentiment And Currencies
Why is it important for traders to look at equities and risk sentiment?
Equities can be used as a good gauge for risk sentiment in the market. Moves in global equities can precede moves in risk related currencies.
Some studies showed that moves in the JPY and Nikkei225 are 83% inversely correlated.
The Swiss National Bank did a study on risk sentiment in 2016. They found that the JPY and CHF reacted significantly with changes in risk sentiment.
There are two points that are important here.
- The JPY and CHF appreciates during risk-off sentiment and depreciates with risk-on tones
- The AUD, NZD and CAD depreciates during risk-off and appreciates with risk-on tones
How can we use all this information in our trading?
Equities can be a leading indicator for possible risk sentiment. When global stocks are up or down across the board, we need to pay attention.
The first step is to see whether a move in equities confirms a risk-off or risk-on tone. The second step is to choose the relevant currencies.
If it’s a risk-off tone, we can look to buy the JPY and CHF. We can also look to sell the AUD, NZD and CAD. The opposite is also true.
According to IG, commodities are natural resources or agricultural products.
Some of the most common commodities are:
- Precious and base metals (Gold, copper, iron ore etc.)
- Oil-related products (Crude, WTI, natural gas etc.)
- Agricultural Products (Grain, Corn, Dairy etc.)
The bulk of commodity trading comes from speculators trading in the futures market. Traders in the futures market bets on whether commodity prices will rise or fall.
There are four main drivers of commodity prices:
- Supply and Demand
When demand outweighs the supply commodity prices rise. When supply outweighs demand commodity prices fall.
- Economic and Political events
Economic or political events can affect commodity supply and demand. This can drastically impact commodity prices.
A recent example of this was US Oil sanctions on Iran.
- The Weather
Bad weather or natural disaster can constrain commodity supply. This will normally cause commodity prices to rise.
- The US Dollar
A strong Dollar makes commodity prices cheaper. Where a weaker dollar makes commodities more expensive.
Commodities And Currencies
Some countries are very dependent on commodities for their exports. When commodity prices fluctuate it has ripple effects on commodity dependent economies.
If a country is dependent on oil, it’s economy will be impacted by changes in oil prices. This is also true for other commodities as well.
Let’s look at a few examples. Canada is a major producer of Oil. When Oil prices fluctuate it affects the Canadian economy.
The above chart shows the correlation between the Canadian dollar and oil prices.
Another example is the Australian Dollar and base metals. Australia is one of the world’s biggest producers of base metals.
When base metal prices fluctuate it affect the Australian economy.
Above is an example of the Aussie Dollar versus the Australian Miners Commodity Index (AXMM).
Why is this important for Forex Traders? When commodity prices fluctuate, we can expect similar moves in correlated currencies.
This is especially true during risk-on and risk-off tones in the market. Commodities are considered as risky assets.
This means they appreciate in risk-on and depreciate in risk-off sentiment. This explains why the AUD, CAD and NZD normally move in the same way.
This can give us a unique advantage in the markets are Forex Traders.
Commodities And Interest Rates
The commodity markets can also affect monetary policy. More specifically Oil prices.
Inflation is one of the main factors Central Banks uses to adjust interest rates.
Oil prices are one of the biggest influences of inflation.
The above chart shows the correlation between US CPI YY and Oil prices. Notice how oil acted as a leading indicator for inflation.
Inflation impacts interest rates and interest rates impacts currencies.
This is a very valuable Intermarket correlation to take note of.
The Right Approach To Intermarket Analysis
Intermarket analysis is “not really meant to work on a tick by tick basis”. One pip move in bonds won’t necessarily affect other asset classes.
Traders can use other asset classes to give them a broader view of the market. It should not be used as strict rules in trading.
Changes in oil will not always affect the Canadian Dollar. Base metals will not always affect the Aussie Dollar. It depends on what the market is focused on.
Asset class correlations will not work during all market conditions. Inflation and interest rates are essential in our Intermarket analysis.
Remember that the market is fickle. Do not trade correlations based on fixed rules.
Focus on the market’s reaction relating to the correlation. If the market is not paying attention, you don’t have to either.
In this article, we learnt how bonds, equities and commodities can affect currencies
Understanding asset class correlations can give traders a unique edge in the markets.
Don’t worry if including Intermarket analysis into your trading seems a bit daunting. With a bit of practice, it can become second nature after a while.
There are a couple of things you can do from tomorrow to help with this.
- Find websites that give live equity market performance
There are a bunch of free websites that will provide this information. Start to look at equity markets and notice when they are up or down across the board.
Compare this with currency moves in the JPY, CHF, AUD, CAD and NZD. Start getting used to the way the markets react.
- Read analyst commentaries about the market
Read up on what investment banks and analysts are saying about the markets. Take special note when they use terms like risk-on or risk-off.
Look at the currencies and charts they are referring to. This will help you gain insight into how analysts apply Intermarket analysis.
- Take your time
Rome wasn’t built in a day. Neither are skills.
Take your time to analyze and study market correlations until you are comfortable. Don’t rush into any trade hastily just because certain assets are moving.
Always see how the market reacts to intermarket correlations before you jump in. If the markets don’t care, you shouldn’t either.
We wish you all the best with your intermarket Analysis.
If you have any questions or comments, feel free to let us know in the comment box below.