Intermarket analysis was popularized by the eminent financial analyst John J. Murphy in his book: Intermarket Analysis: Principles of Interaction of Financial Markets. Subsequent developments in the technology of neural networks in relation to various types of analysis have made this topic more and more relevant for today's trader.
This type of analysis simultaneously takes into account changes and inter-market correlations between the four main financial markets:
- Currency market.
- commodity market.
- Bond market.
- Stock market.
Above all, intermarket analysis can be used to determine the current dynamics of global business cycles. Therefore, his methods can provide useful long-term forecasting tools for investment market analysts and business leaders.
How to use intermarket forecasting methods?
Fluctuations in exchange rates can seem quite erratic and even random as traders take in new information, form new opinions, and influence market price movements accordingly. However, despite the occasional price change, analysts regularly note that market behavior forms certain patterns. Also, these patterns tend to repeat themselves and, therefore, may contain some value in terms of predicting the future direction of the market.
Price patterns and patterns can be observed in almost all markets and on all timeframes. Given the global nature of financial markets and the ability of traders to quickly perceive and react to new information, related markets are now increasingly correlated as their participants respond to the same geopolitical and economic information that is now rapidly spreading around the world.
These interconnections between global markets mean that traders need to constantly monitor what is happening in other adjacent markets, and not just focus only on technical analysis .
Intermarket analysis provides traders with new advantages in an increasingly global and interconnected financial market, in which the foreign exchange market plays a key role along with the securities and commodities markets. Learning how to apply and use intermarket analysis in your trading decision process can make the difference between winning and losing trades.
Key components of intermarket analysis
Key markets, that is, the foreign exchange, securities and commodity markets, as a rule, are closely related to each other and constantly interact with each other. These well-established correlations allow analysts to make predictions about future price movement based on constant observations in correlated markets.
A positive correlation implies that the correlated markets tend to move in the same direction, while a negative correlation means that the related markets will generally move in the opposite direction.
As John J. Murphy writes in his book on intermarket analysis, market analysts have observed a number of key relationships among stock, bond, currency and commodity markets over the years. They can be described as follows:
- Trends in commodities and the US dollar tend to be negatively correlated. This implies that if the US dollar has been falling lately, this fact is considered bullish for commodity prices.
- Commodity and bond prices tend to be negatively correlated. At the same time, commodity prices and interest rates tend to be positively correlated. When commodity prices rise, it will usually be bearish for bond prices and bullish for interest rates.
- Bond prices and stock prices tend to be positively correlated, while interest rates and stock prices tend to be negatively correlated. This relationship indicates that rising bond prices and falling interest rates tend to be bullish for equities, while falling bond prices and rising interest rates tend to be bearish for equities. This is the most common relationship observed due to the general prevalence of positive inflation in most major economies.
- A sharp rise in bond prices followed by a fall in stock prices is an indicator of deflation.
- The bond market usually changes direction earlier than the stock market. As a result, bond price reversals can be seen as a leading indicator of stock market reversals.
- A rising currency tends to be positively correlated with the prices of stocks and bonds denominated in that currency. This means that an uptrend in USD will be bullish for the US stock and bond markets, while a downtrend in USD will be bearish for US stock and bond prices.
- If commodity prices rise, the depreciation of the US dollar tends to lower the prices of US stocks and bonds. Conversely, if commodity prices decline, the rise in the value of the US dollar will typically be bullish for US stocks and bond prices.
Such correlations are fundamental in the relationship between inflation, interest rates, and the valuation process of stock, currency, bond, and commodity markets. Moreover, these relationships can also be analyzed by other methods, primarily those related to the field of technical analysis.
Intermarket analysis in practice
One of the most common methods of intermarket analysis is to observe the dynamics of price changes in each of the four financial markets. As in many areas of market analysis, one of the main tools of intermarket analysis is to chart prices and exchange rates and observe their dynamics.
For example, intermarket analysts often overlay performance charts of four key markets to observe trends and deviations from expected relationships that new trading opportunities may provide. Performance charts allow the analyst to compare how different markets have performed in key trends over a period of time. This type of intermarket technical analysis allows the analyst to evaluate the performance of an asset as percentage changes observed over time.
The following figure shows an example of what such an intermarket analysis performance chart might look like. The cross-market comparison performance graph shows performance values for the S&P 500 stock index, the Thomson Reuters/Jeffries Core Commodity CRB commodity index, the US dollar index, and 10-year US Treasuries. Each of the lines on the chart represents the percentage change observed for a particular asset.
This form of graphical analysis allows an analyst or trader to see how intermarket relationships develop over time.
Currency trading and intermarket analysis
Many forex traders first encounter the concept of intermarket analysis when they observe the correlation between the value of the currencies they trade and key strategic commodities such as gold and oil.
The Australian dollar, Canadian dollar and New Zealand dollar are even referred to as "commodity currencies" due to the correlation between their relative value and the price of some key commodities such as gold.
Some of the most important currency and commodity relations are:
- The price of gold and the value of the US dollar tend to be inversely correlated. This is because investors tend to sell fiat currencies like the US dollar in favor of holding hard assets like gold in times of economic or geopolitical crisis.
- The price of gold and the value of the Australian dollar tend to be positively correlated. This relationship persists due to Australia's position as the third largest producer of gold in the world. Australia currently exports about US$5 billion worth of gold each year, making its economy very sensitive to the value of the yellow metal. Therefore, an increase in the price of gold tends to increase the AUD/USD rate.
- The price of gold and the value of the Canadian dollar tend to be positively correlated. Like Australia, Canada is a major gold producer, ranking fifth in the world. Thus, when the price of gold rises, USD/CAD tends to fall as the Canadian dollar rises.
- The price of gold and the value of the New Zealand dollar tend to be positively correlated. New Zealand is also a significant net exporter of gold such as Canada and Australia.
- The price of gold and the value of the euro in the European Union tend to be positively correlated. This is because when money exits the US dollar, it tends to flow into other assets such as gold and the euro. Therefore, an increase in the price of gold will also be accompanied by an increase in the euro against the dollar.
- The price of gold and the value of the Swiss franc tend to be positively correlated. The Swiss franc is the safe-haven currency. Although the Swiss currency is no longer required to be backed by 40 percent gold reserves by law, the Swiss National Bank still maintains significant gold reserves, making its currency more valuable than other countries' currencies. Therefore, an increase in gold prices will be accompanied by a depreciation of the US dollar against the Swiss franc as the Swiss franc strengthens.
Oil-related currency correlations :
- The price of oil and the value of the Canadian dollar tend to be positively correlated. This relationship is driven by Canada's status as one of the world's largest oil exporters, selling roughly two million barrels of oil every day to the United States alone. Therefore, rising oil prices will tend to depreciate the US dollar against the Canadian dollar as the rate rises.
- The price of oil and the value of the Japanese yen tend to be inversely correlated. This relationship arises because Japan is a net importer of oil. Therefore, rising oil prices will tend to push the USD/JPY exchange rate higher as the Japanese yen weakens.
Relations between the currency market and the stock market
In addition to the aforementioned commodity price ratios, some currency pairs also react to changes in their respective stock markets.
For example, when the Japanese Nikkei stock market index falls, the USD/JPY also tends to decline as investors consider the Japanese yen a safe investment and therefore appreciates in value.
Another, perhaps more complex, relationship between a currency and the stock market has to do with risk perception and the relative degree of risk aversion among investors in the market. When investors are less risk averse and therefore willing to take risks, the stock market tends to rise. Likewise, currency pairs such as AUD/USD, NZD/USD and EUR/JPY will also tend to rise in this situation, while pairs such as USD/CAD, EUR/AUD and GBP/AUD will tend to decrease.
On the other hand, when investors seek shelter because they become more risk averse, the stock market tends to fall. In this situation, currency pairs such as AUD/USD, NZD/USD and EUR/JPY will also tend to fall, while pairs such as USD/CAD, EUR/AUD and GBP/AUD will tend to growth.
Development of a trading strategy based on intermarket analysis
Once traders learn about intermarket analysis, most of them will want to know how they can use it in their trading. They also usually want to know how to apply intermarket analysis in practice and how to develop a profitable intermarket trading system based on this information.
Numerous details related to the development and testing of an intermarket trading system are beyond the scope of this article. However, as a starting point, an interested trader can learn how to create and use correlation charts, such as the chart shown in the figure above, which is a key intermarket analysis tool.
Traders should also be aware of the typical relationships between currency valuations and commodity or stock market movements detailed above. Thus, when they see a sharp move on one side of a correlated pair of markets due to some unexpected news event, they can expect the particular currency pair to rise or fall accordingly depending on whether the correlation is positive or negative.