Intermarket AnalysisEconomics and Currency
In the financial world, no market acts by itself. Every single market acts in relation to every other market. They all are dependent on the same economic situation, but they react in slightly different ways. This allows a method of analysis called “Intermarket Analysis”, which uses the movement of markets to confirm biases for other markets and increase confidence in estimated trends.
There are effectively six core asset classes in the financial markets: Bonds, Commodities, Currencies, Real Estate, Loans, and Stocks/Equities. All derivatives are based on these asset classes. Let’s review how 4 of them interact in relation to economic growth, interest rates, and inflation. This allows you to infer how they will interact with each other, and under what circumstances, these relationships will break.
Bonds have an inverse price relationship with economic growth, interest rates, and inflation. If economic growth is occurring, prices are bid up by increasing demand for commodities, goods, and services. At the same time, increasing money supply printed by central banks increases the amount of money chasing the same goods. The result is inflation. Eventually, inflation grows too quickly. The central bank will increase interest rates to reduce further inflation. An increase in interest rates will increase the interest rates paid by new bonds, making their payouts higher than old bonds. If new bonds are issued at the same price as old bonds, the old bonds will decrease in value. Why buy an old bond paying a lower rate when you can have a new bond paying a higher rate for the same price? The price of existing bonds goes down when interest rates increase.
Sometimes interest rates go down because inflation is decreasing or doesn’t exist, due to a lack of economic growth or an economic contraction. In that case, why buy a new bond at a lower rate, when you can buy an older bond that pays a higher rate at the same price? They’ll buy older bonds at the same price paying higher rates first, and old bond values will rise. In this case, bond values above the old interest rates will go up when rates decrease.
Bonds increase in price as interest rates fall. Bonds decrease in price as interest rates rise. If not holding to maturity, you should have the highest confidence for purchasing bonds after interest rates have already been raised substantially, when interest rates are most likely to fall. As interest rates fall, the old bonds above the rates will increase in value, since they can no longer purchase bonds at that fixed payout level. Those bonds can then be sold in the secondary market at high prices when interest rates bottom out, you would theoretically sell as interest rates start to rise again.
Commodities have a direct price relationship with economic growth and inflation, and leading relationship with interest rates. As stated already, economic growth bids up demand for commodities, goods, and services. This creates inflation, which is literally the increase in prices of goods, services, and the resources (aka Commodities) that create them. Eventually, interest rates are raised to counter inflation. When interest rates are raised, the accessibility of credit decreases, borrowing slows due to higher interest costs, buying on debt slows, demand slows, and inflation slows. Commodity price increases will slow overall.
When economic growth collapses and economies contract, demand for goods, services, and commodities decrease. Inflation becomes disinflation or deflation. To prevent economic collapse and stimulate the economy, interest rates are lowered.
Commodities are thus based directly on economic growth and industrial production, and are inflation themselves. You should have the highest confidence purchasing commodities after you see signs of rising industrial production, rising gross domestic product, and rising probability of interest rate increases. This is the time period inflation is most likely to occur.
You should have the lowest confidence in holding commodities as demand begins to fall for those commodities. This occurs after the economy peaks, production falls, and gross domestic product contracts (turns negative). During this time period, disinflation or deflation is most likely to occur.
The strength of a currency market moves inverse to inflation and directly with interest rates. Economic Growth drives inflation, since demand for goods, services, and natural resources/commodities used to create them rises during economic expansions. As Interest Rates rise, the demand for a currency will also rise, since investors can receive more money for lending in that currency. As interest rates fall, this incentive decreases, demand falls, and investors may leave the currency for others.
Stocks move favorably with economic growth and inversely to interest rates. Economic growth drives consumer’s ability to spend, and corporate profits. Eventually, the increase in demand reaches the resource level and affects commodities, resulting in inflation. Inflation will hinder profits by increasing the cost of resources businesses use. Rather than eat these costs they normally pass the cost increase onto consumers. They may reduce demand for goods, but real corporate earnings should remain roughly the same. Beware if they are decreasing as inflation rises. Eventually, central banks will raise interest rates to reduce inflation. An increase in interest rates increases the cost to borrow and the rate of existing variable rate loans for consumers and businesses. Consumers may cut back on consumption to meet interest payments, lowering demand. Businesses will be forced to borrow at higher rates, increasing interest costs. Both lower consumer demand and higher interest costs can reduce corporate profits.
Bonds Versus Commodities
Anytime you have an estimate of trending inflation, you should look at Commodity and Bond markets to confirm it. While Commodities positively rise during inflation, Bonds fall in value due to purchasing power loss and the risk of interest rate hikes. They move in opposite directions.
Inflation is good for the value of commodities but will hurt the value of bonds.
Disinflation or Deflation is bad for the value of commodities but will increase the value of bonds.
Bond yields increase when bond prices decrease. Bond yields move with commodities.
In order: Rising Commodity Prices, Rising Inflation, Increasing Interest Rates, Falling Bond Prices, and finally Rising Bond Yields.
You can use any commodity index but should be aware that commodity indexes are not all weighted in the same way. Some have higher priority towards agriculture, metals, woods, or energies. Note that this doesn’t mean that every single commodity will move in opposition to the bonds all the time since they have their own market interaction and factors.
There are multiple commodity indexes you can follow to track inflation when comparing it against bonds. The first is the Reuters/Jefferies CRB Index uses 19 different commodities markets. The second is the Goldman Sachs Commodities Index or S&P GSCI. The third group worth following is precious metals, they are traditionally seen as a hedge against inflation: Gold, Silver, and Platinum. Finally, the Fourth group is industrial usage metals. This includes Copper, Lead, Aluminum, and Irons. Simply use any chart comparison function to compare treasury bonds and any of the commodity indexes.
Currencies Versus Commodities
Commodities are priced against currencies, specifically the US Dollar worldwide. When the Dollar is rising, currency values priced in US Dollar are usually falling. When the Dollar is falling, currency values priced in US Dollar are usually rising. Generally speaking, Commodity Indexes should be falling as the US Dollar rises. The Dollar Index will move opposing commodity indexes.
The Dollar can be followed using the DXY Dollar Index. Any other currency can be followed the same way by creating a basket of currencies using daily returns and comparing that to Commodity Indexes. This is commonly done in Excel or any other formula spreadsheet software.
Bonds Versus Stocks
Bonds and stocks typically, but don’t always, move in the same direction. This does not occur under two circumstances: Extended Low/Zero rate periods, and deflationary fears. In these circumstances, they decouple and move in opposing directions.
If interest rates are near zero or negative, purchased bonds don’t provide cover from inflation. This is especially true if rates are near zero or negative for an extended period of time. In this circumstance, investors who typically would select bonds are forced to flee to other asset classes to avoid a loss of purchasing power. If they flee to stocks, shares will increase in value while bonds fall lower.
During Deflationary Periods, bonds have no fear of being outpaced by inflation, since it is contractionary. The prices of corporate and government bonds are likely to rise since fixed rates offer a refuge from deflation. Stocks, which derive value from corporate profits, carry the risk of being caught in a deflationary cycle or spiral. The fall in demand triggering the deflationary period creates low sales, low sales translates to losses at companies, followed by a loss of employment by labor, and further decreases in demand. Losses in companies create a fall in equity values. This continues until consumers come to the table to end the spiral. As a result, while bonds retain or increase in value, equities fall, and their paths diverge.
Bond Yields move in the opposing direction of Bond Prices. If Bonds are sinking whilst Stocks are rising, Bond Yields will move in the same direction as Stock markets.
Adoption of an Intermarket Strategy
Creating an Intermarket Analysis derived strategy position consists of three steps. The first step is using economics to derive the path of the economy. Using economic indicators (also found in the economic curriculum section), figure out where you are in the business cycle and the likely actions of central bankers and other market participants.
The second step is using the economics and the proposed path of the economy, to project a leading asset class. For example, use American and Global economic indicators to infer where the US Dollar, the world’s reserve commodity currency, is going. Combine this with Federal Reserve Central Bank statements and opinions. Then, technically analyze the US Dollar Index (DXY) and note its trend and pattern structures.
Third, use the relationships between asset classes to estimate where other asset classes are going based on the relationships. Be sure to note if you are in an inflationary or deflationary time period, since relationships will change depending on the perceived risk.
Look at bonds prices/yields, bond indexes/ETFs, commodity futures, commodity ETFs, commodity stocks, currencies heavily tied to the export of a specific commodity, and equity indices. Note that these relationships aren’t instant and often lag. Let the leading asset move, then wait on confirmations. For example, commodities will move, then commodity currencies will move, then commodity stocks will move. Using multiple assets to confirm the overall theme will help you become more accurate.
Finally, let price trends begin, then ride trends using substantial risk management measures. Take entries into trends as they appear, stacking small positions over time so you don’t take too much risk. Lock in gains, and let losses stop out for small amounts of capital.
Here’s a step by step checklist:
- Where are we economically now in the Dollar Index, 10 Year Yield, and Commodity Indexes? Why?
- Are we in an inflationary, disinflationary, or deflationary environment? Which is currently feared by the market?
- What do the economic indicators in America imply about the path of future GDP and US Dollar Reserve Currency Inflation?
- Is there an inflationary or deflationary environment coming?
- What are Central Banks likely to do as a response to the inflationary or deflationary future?
- In Deflationary fears, Central Banks lower interest rates. In Inflationary fears, they raise interest rates.
- How will their reaction affect bond prices and bond yields?
- How will the economic path affect the Dollar and affect Commodities?
- If the economic indicators show growth, economic expansion, rising demand, further inflation, rising commodities value.
- If the economic indicators show contraction, economic slowing, rising demand, disinflation or deflation, falling commodities value.
- How will the rise or fall of commodities affect the value of commodity currencies? Which ones?
- How will the rise or fall of commodities affect the value of commodity equities? Which ones?
- How will the economic path affect Equities?
- Deflation and Stagflation hurt equity values.
- During economic expansion, inflation has little effect on equities as long as it is not hyperinflation.
- What intermarket trends are we looking for to enter in the Dollar, Bonds, Commodities, Commodity Currencies, and Equity Indices?
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International Economic Analysis:
- Major Currency Economic Summaries
- Performance of Major Imports and Exports
- Mandates of Central Banks versus Expectations
- Performance Indexes of Major Economies
- Economically Correlated Currency Projections
- Large Funds Currency Sentiment Readings
- List of Technical Indicators to Look For
- Occasional: Foregin Exchange Technicals Markups
American Markets Analysis:
- Summaries of American Economic Structure
- Performance of Major
- Federal Reserve Mandate versus Expectations
- Performance Indexes of U.S Economy
- Economically Correlated U.S Dollar Projections
- Large Trading Fund Index Sentiment Readings
- Market Wide Earnings Versus Valuations
- Fundamental Ranking of U.S Business Sectors
- Best and Worst Future Consensus Estimates
- Occasional: Firm Fundamental Strength Report
- List of Technicals to Look for While Trading
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