Relationships between Markets

In most market cycles, there is a general order in which commodities, shares, bonds and currencies move. As all four work in tandem, by watching all of them we can better determine the direction in which a particular market will move.

A basic rundown of the interaction between these markets is as follows -

Climbing commodity prices drive up the cost of goods. As price rises are inflationary, central banks increase interest rates to fight inflation. Bond prices and interest rates often have an inverse relationship, meaning that bond prices drop as interest rates go up. As higher interest rates means that borrowing has become more expensive, and the cost of doing business rises as a result of inflation, companies don’t perform as well. This reveals a correlation between share prices, stock indices and bond prices as, when bond prices fall, share prices soon follow.

The forex market has an impact on all markets (clearly, as all markets use currency to function), but its relationship with the commodity market is the most significant. Commodity prices impact bonds and, subsequently, shares. As commodity prices are denominated in US dollars, the USD and commodities usually trend in opposite directions (as the USD is worth less, the price of commodities in US dollars go up).

Using this in your trading

Although inter-market relationships will not give you exact buy or sell signals, they are a useful tool for confirming trends, and can also warn of potential reversals.

Commodity price rises accelerate in inflationary environments, meaning that in time this will weaken the economy. If commodities are going up, bonds have started to fall and shares are still climbing. These relationships will overcome share bullishness, which will be forced to retreat due to inflation and interest rate rises. That being said, rising commodity prices should not be used as a signal on their own to go short, they just indicate an impending reversal if bonds continue to fall.

At this point traders should keep an eye out for shares breaking through major support levels, or falling below a moving average after bond prices have tumbled, as this would be a confirmation of the reversal.

Does this work in every environment?

Although the markets are all connected, there are circumstances when these relationships break down. In the 1997 Asian crisis, US markets saw shares drop as bonds went up, and then shares went up as bonds fell. The reason behind this break in the relationship was because typical market relationships assume inflationary economic environments.

Consequently, in deflationary environments, these relationships will change.

Deflation usually drives the share market down. Without growth potential, shares are unlikely to head higher. Meanwhile bond prices will rise to reflect falling interest rates, as bond prices have an inverse relationship. This means that the type of economy we are in will impact whether shares and bonds are positively or negatively correlated.

At other times, one market will remain static. However, the relationships between other markets still apply – if companies expand internationally, they will continue to grow in value if the domestic currency falls as the value of the money coming in will be worth more when converted into the domestic currency.

Conclusion

Analysing inter-market relationships can be a valuable tool, as long as traders don’t expect these relationships to hold true 100% of the time. To effectively apply this to your trading, it is important to understand the shifting dynamics of the economy in which you are trading, and why these could cause deviations from the typical relationships.

This article was written by Jacqueline Pretty – IG Markets. No representation or warranty is given as to the accuracy or completeness of the above information, consequently any person acting on it does so entirely at his or her own risk. IG Markets accepts no responsibility for any use that may be made of these comments and for any consequences that result.

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