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.

How is the exchange rate determined and who regulates it?

Every day we hear about exchange rates in the financial news. This data is used in everyday life when planning overseas trips, shopping internationally, and building foreign currency savings to protect against inflation. Forex traders also deal with fluctuations in currency pairs on a daily basis, analyzing quote charts for the most profitable deals, assessing the economic state of countries and predicting future trends in the market.

But how exactly is the exchange rate formed? What does the euro rate depend on and what does the dollar rate affect? Let’s understand where quotes come from and who determines their value.

What is the exchange rate?

The exchange rate is the value of one currency expressed in units of another. This price is constantly changing on the chart, creating so-called quotes. In Forex, currency pairs are labeled as follows:

XXX/YYY

where XXX is the currency whose rate is being determined and YYY is the currency in which the value is calculated. For example, if the EUR/USD exchange rate is 1.2300, it means that 1 euro is worth 1 dollar and 23 cents.

Factors affecting the exchange rate

A lot of factors affect the exchange rate:

  • Supply and demand. Currencies are bought and sold like commodities, and investor interest determines their value.
  • Economic indicators. Inflation, unemployment rate, GDP, and other indicators gauge a country’s economic strength and stability.
  • Monetary policy. Central banks’ decisions on interest rates and money supply management affect inflation and confidence in a nation’s currency.
  • Political and economic stability. Emergencies such as wars, sanctions, crises, and natural disasters can cause capital outflows and alter currency exchange rates.
  • Global market events. Changes in sentiment in financial markets, especially those related to the currency of interest, also affect quotes.

Who shapes the exchange rate?

The most objective ratio of currency values is established in financial markets, where supply and demand reflect the reaction of market participants to global events. Private traders make money on the difference in exchange rates by buying currency cheaper and selling it more expensive through intermediaries – brokers. The exchange rates we see in the news are set by the Central Bank on the basis of transactions on the Moscow Exchange. These are average values of currency value calculated on the basis of trading results, and they serve as a benchmark for exchange operations in the country.

Who regulates exchange rates?

Central banks or similar government organizations regulate exchange rates. They use various instruments:

  • Interest rates. Rising rates strengthen a currency, making it attractive to investors, while falling rates in a crisis help stabilize the economy.
  • Open market operations. Central banks can use internal reserves to intervene in exchange rate movements.
  • Money supply control. Regulating the amount of money in circulation affects inflation and the exchange rate.
  • Currency interventions. In cases of severe volatility, central banks can stabilize the market.
  • Currency regimes. Countries can choose different policies for free floating and convertible currencies, from fully floating to fixed exchange rates.

Forex trading process

Forex (Foreign Exchange Market) is one of the largest and most liquid financial markets in the world. It is an over-the-counter market and has no specific location. The rates of currency pairs are determined by the supply and demand of market participants, including central banks, commercial corporations, investment funds and private traders. Each participant influences the quotes in its own way depending on the volume of transactions and strategies.

Conclusion

We have understood how the exchange rates we see in trading terminals, news and exchange offices are formed. This process involves many large financial organizations, companies and private investors whose actions affect the quotes. Understanding the factors that influence exchange rates is important for analyzing and predicting the market, as well as managing the risks associated with their fluctuations.

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.

What is a spread in the financial markets?

Any trader or investor comes to the financial markets with the purpose of making money. He or she seeks to buy assets cheaper and sell them more expensive, capitalizing on the price difference between the associated commodities and expected market movements.

In any case, the trader analyzes the price and its fluctuations between sellers and buyers, which in financial markets is called a spread.

Let’s take a look at what a currency spread is and what other types of price ranges exist on exchanges.

What is a spread

In the financial context, the concept of “spread” (from the word “spread” – divergence) can differ depending on the type of asset. In general terms, a spread is the difference between two price values for the same or similar instruments.

For example, it can be the range between:

  • The prices of sellers and buyers in the market at a given moment.
  • Prices for one asset: currency, stocks, futures at the current moment and after a certain period of time.
  • Prices for the same type of commodity, but of different brands, etc.

The most common variant in trading and investing is the difference between the bid and ask price (Bid – Ask). This is a commission for each transaction, which makes up the broker’s profit.

This is how, for example, the currency spread is formed. The exchange glass helps to better understand this concept. It is a special table formed by a market maker, where all limit orders from sellers and buyers of an asset are reflected. Bids are placed depending on their proximity to the current quote: the closer supply and demand are to the current price, the smaller the currency spread is. Since orders on active pairs are quickly satisfied and removed from the stack, the spread is constantly changing.

The spread for CFDs on shares and other securities is formed in a similar way. It can be several dollars, cents or even a fraction of a cent, so it is usually denoted in points. For example, if the price of NASDAQ 100 index is 11760.5/11761.3, the spread will be 8 cents or 8 points. This value is displayed in the market overview and in the glass.

It is believed that the smaller the spread, i.e. the closer the price of buyers and sellers, the more liquid the asset. This means that a trader is highly likely to be able to buy or sell it at the right time at an adequate price.

Types of spreads

Depending on the type of exchange-traded or OTC asset, the concept of “spread” can vary.

Currency spread

If we talk about the spread as a difference between bid and ask prices, as in the case of currency pairs or CFDs, it can be divided into fixed and floating spreads.

A fixed spread does not change regardless of market conditions: even when important news is released, when supply and demand shifts sharply. This level is set and maintained by the broker. It is usually higher than the standard floating spread in a calm market and lower in times of increased volatility. Today fixed spreads are rare, they have been replaced by market spreads.

A floating or market spread depends on supply and demand in the exchange stack and changes according to the preferences of traders. Usually for volatile assets it is more favorable than the fixed one and can be equal to zero at times. However, at the moments of important news release such a spread logically widens, so many brokers warn their clients about it.

Market spreads

There are intermarket and intramarket price ranges.

Intermarket spread reflects the difference in the cost of the selected asset on different exchanges, which is typical for securities. An intra-market spread is the difference between highly correlated or related instruments, for example, between stocks and their ADRs.

A special type of intra-market spread is the calendar spread, which exists in the derivatives market. It shows the difference in the prices of contracts for the same asset with different expiry dates.

Futures spread

This type of spread represents a trading strategy. Unlike a currency spread, a futures spread is a method in which a trader simultaneously buys and sells contracts on identical or similar commodities to profit from the divergence of their prices.

A futures spread occurs when:

  • Buying and selling a contract for the same asset with delivery in different months.
  • Buying and selling futures on different assets with similar quotation dynamics (correlation).
  • Buying and selling contracts for the same commodity of different quality.

Factors affecting the spread size

The size of the currency spread and similar spreads is influenced by various factors relating to a particular financial instrument. The main ones are:

  • Liquidity of currencies and securities: The higher the liquidity, the lower the spread. A large number of traders and market participants interested in transactions with this instrument leads to an increase in buy and sell orders and increases the chances of quickly concluding a deal at the right price.
  • Volume of trades and transactions: On stock exchanges, large transactions lead to a widening of the spread as many limit orders are executed at the same price.
  • Transaction amount: If an asset is purchased for a very small or very large amount, there are additional brokerage fees that increase the commission.
  • News and Publications: The main drivers of markets. Buy or sell decisions are often made based on them. After news releases, demand or supply increases sharply, causing the spread to widen. Before important news, trading activity drops, liquidity decreases and the spread widens.

How to work with the spread

It is impossible to artificially influence the stock or currency spread, as it depends on market conditions. But in order to reduce costs, you can:

  • Do not trade at times of low liquidity and the release of important news.
  • Open accounts with floating spread and choose active trading hours.
  • Choose popular currency pairs and securities.

Spread is less important for long-term strategies, but in this case you should take into account another parameter – swap (if it is applied).

Opening positions with limit orders can significantly reduce risks and additional costs, especially for large transactions or work with unpopular assets.