Intermarket Analysis

Commodity, stock, currency and bond markets are closely interconnected. Understanding their interactions allows traders to develop effective trading strategies. Together with technical buy and sell signals, this information greatly enhances the accuracy of the analysis. When one of the markets begins to show leading signs, you can better customize your analysis.

Fundamentals of intermarket analysis

Often reversals are preceded by divergences. For example, if the dollar strengthens, we can expect commodity prices to decline. If this does not happen immediately, it is a sign of divergence and commodity prices are likely to start falling soon.

Another example: declining bond prices when stocks are rising. While this trend may continue for a while, in an inflationary environment, stocks will eventually follow bonds. To confirm trends, we can assume that existing relationships will continue: if commodity prices rise and bonds fall, this movement will continue. Similarly, the fall in stocks is likely to continue while bonds are falling and for some time after they stabilize.

Global Divergences

By utilizing the correlations between global markets, it is possible to extend the analysis by confirming the conclusions with other markets. It is ideal when global markets confirm what is happening in the local market. For example, if the U.S. stock market is rising and overcoming resistance, the trend is considered strong if other global markets show similar dynamics. Markets with strong correlations, such as those in the Eurozone, Canada or China, should be watched.

In 2008, the synchronized decline in global markets confirmed the strength of the downtrend. Although there may be time lags between the movements of different markets, strong trends should appear synchronized. If the other markets are stable, it is unlikely that U.S. markets will experience a significant decline without confirmation from other global markets.

Assets that reflect cross-market correlations

Having received signals from various markets that a new trend is ready, individual stocks can be used to pinpoint the start of the trend. For example, stocks that are highly correlated with the price of oil and financial sector stocks that are sensitive to interest rates.

These stocks often outperform their respective futures markets, allowing you to predict their movements. The upward movement of commodity stocks confirms the market’s readiness for a bullish trend. For example, in 2008, oil stocks peaked and retreated ahead of oil prices, which foreshadowed their imminent decline.

Financial and service sectors

The bullish performance of interest rate sensitive stocks points to weakening inflation and rising liabilities, suggesting lower interest rates and a possible rise in equities. The strengthening of financial sector stocks at the end of a market cycle is supported by gains in industrial and technology sector stocks. Service sector stocks often move in sync with bonds, confirming trends in the Treasury market.

Conclusion

When global markets confirm movements in the local market, it confirms the continuation of the current trend. Tracking stocks leading asset classes provides early indications of the beginning of a move. Understanding intermarket relationships helps you select the most promising market to open a trading position based on trends. This approach is effective for medium to long term trades, but requires consideration of events that can disrupt intermarket relationships.

History of Forex

Bretton Woods Agreement

In 1967, the Chicago Bank refused to make a loan in pounds sterling to Professor Milton Friedman, who planned to use the funds to sell British currency. Friedman believed that sterling was overvalued against the dollar and intended to sell the currency and then buy it back at a lower rate to repay the loan and make a profit. The bank’s refusal was based on the provisions of the Bretton Woods Agreement, made twenty years earlier, which fixed exchange rates against the dollar, and the dollar against gold, set at $35 per ounce.

The Bretton Woods Agreement was signed in 1944 to maintain financial stability in the world by limiting capital flows and currency speculation. Prior to this, from 1876 until World War I, the international economic system was based on the “gold standard,” in which currencies were tied to the price of gold. This provided stability by eliminating the practice of currency devaluation and inflation.

However, the gold standard had its drawbacks. Economic growth in one country increased imports, which reduced its gold reserves and reduced the money supply. This raised interest rates and slowed economic activity until a recession hit. Then prices fell, goods became attractive to other countries, causing gold to flow in, increasing the money supply and lowering interest rates, contributing to an economic recovery. Such cycles dominated until World War I disrupted trade flows and the free movement of gold.

After the two world wars, the Bretton Woods Agreement was established whereby countries pledged to keep the exchange rates of their currencies within narrow limits relative to the dollar and gold. Devaluation of currencies to gain trade advantages was forbidden, except up to a maximum of 10%. In the 1950s, with the increase in international trade brought about by the post-war recovery, there were significant capital movements that destabilized the exchange rates set at Bretton Woods.

In 1971, the agreement was finally abolished and the U.S. dollar was no longer convertible into gold. By 1973, the currencies of the major developed countries began to float freely, controlled by supply and demand in the international foreign exchange market. Trade volumes, speed and price volatility increased substantially in the 1970s, leading to the creation of new financial instruments and trade liberalization.

In the 1980s, with the advent of computers and new technologies, international capital movements increased, blurring the boundaries between Asian, European and American time zones. Trading volume in the international foreign exchange market grew from about 70 billion dollars a day (in the 1980s) to over 1.5 trillion dollars a day two decades later.

Euro market

One of the main catalysts for the development of the international foreign exchange market was the rapid expansion of the Euro-dollar market, where U.S. dollars were deposited in banks outside the United States. Other Euro markets developed in a similar manner when currencies were deposited outside their country of origin. The Euro-dollar market emerged in the 1950s when the USSR deposited oil revenues in dollars outside the US for fear of the US authorities freezing the accounts. This contributed to the significant growth of dollars out of U.S. control. The U.S. government enacted laws restricting the lending of dollars to foreigners. Euro markets were particularly attractive because of less regulation and higher returns.

Beginning in the late 1980s, U.S. companies began borrowing abroad, finding the Euro market advantageous for placing excess liquidity, obtaining short-term loans, and financing foreign economic activity. London was and remains the main center of the euro market. In the 1980s, British banks began actively providing dollars as an alternative to pounds in order to maintain their leading position in the global financial market. London’s convenient geographical location, allowing it to work with both Asian and American markets, also contributed to its dominance in the euro market.