Forex Trading with Intermarket Analysis
In forex trading, there is a method of analysis called the Intermarket analysis.
Intermarket analysis is one method of analyzing price movements that examines the relationships and interactions between the four groups of major financial assets, namely stocks, bonds, commodities, and currencies (forex). Professional forex traders always apply Intermarket analysis to maximize profits and reduce risk due to other market influences on the forex market.
In addition, forex traders can also hedge their trading positions by entering markets that trade different types of financial assets.
Intermarket analysis is based on the forex market not being isolated and moving on its own but is part of the dynamics of the global economy and the various types of markets that influence it. Therefore, by looking at price movements in various types of markets, we can get clues about the direction of movement of a currency pair.
In general, an Intermarket analysis in forex trading is carried out by taking into account the movement of the stock price index, bonds, and prices of the world’s major commodities. By knowing the influence of each type of market on the forex market, we can get a signal to predict the direction of movement of a particular currency pair.
Basic Principles of Intermarket Analysis
- In the world financial markets, there are four instruments that influence each other, namely the stock price index, bond prices and yields (government bonds or large corporate bonds), the prices of the world’s major commodities, and pairs of several major currencies (against the USD and cross currency )
- The stock price index is used to determine the direction of money circulation in the global economy. Under normal circumstances, if a country’s stock price index strengthens, the value of the country’s currency will also strengthen. Vice versa.
- Bond prices and bond yields are used to describe the movement of a country’s interest rates.
- The price of the world’s major commodities is used to describe the rate of inflation, as well as the level of demand and supply in some of the world’s major commodity exporters and importers.
Relationship Between Stocks and Currency Markets
Intermarket analysis often starts with the stock price index. The stock market is the main reference for financial markets, while the stock price index represents the price level of a country’s blue chips.
To buy shares of a country, we must use the country’s currency. To invest in major Japanese stocks, European investors must exchange their Euro currency with the Japanese Yen. Increasing demand for Japanese Yen causes the exchange rate to rise. Conversely, the sale of the Euro currency causes the supply to increase, so the exchange rate decreases.
If the market prospects of a country’s stock are good, then a large flow of funds will enter the country to strengthen the exchange rate of its currency. Conversely, if the stock market deteriorates, investors will transfer funds to other countries whose prospects for growth are good, so that the country’s currency will weaken.
As a trader in the forex market, you should also follow the conditions of exchanges in some of the world’s major economies. The flow of money will occur in countries where the stock price index is weakening to a country where the stock price index is strengthening.
That is why a higher stock price index will be followed by a strengthening of the currency; and vice versa. If you buy a country’s currency whose market prospects are good and sell a country’s currency whose stock market conditions are deteriorating, then, of course, you will be able to make a profit.
However, the situation above can only occur in normal global economic conditions. If the world economy is in a state of crisis or global recession, the opposite situation can happen. For example, the correlation between the Nikkei stock price index and USD / JPY
Before the global economic recession that began in 2007, the Nikkei stock price index and the JPY currency were in the same direction, or in other words, the Nikkei index and USD / JPY moved opposite (negative correlation). Thus, if the Nikkei index strengthens, the JPY also strengthens (USD / JPY weakens)
However, after a financial crisis followed by a global recession, the correlation of the Nikkei index and USD / JPY turned positive which means if the Nikkei index strengthens then the JPY weakens (USD / JPY strengthens).
When the stock market of a country represented by the stock price index strengthens, the level of investor confidence in the country is increasing, so the flow of foreign investment into the country will cause an increase in demand for local currency until the exchange rate strengthens.
Conversely, when local stock prices begin to fall, foreign investor confidence decreases, so they redeem local currency investments into the original currency. As a result, the local currency exchange rate will weaken. This phenomenon can be seen in the dynamics of the ups and downs of the economy of the United States, Japan, and Europe.
Every time there is turmoil in the financial markets, the first is the stock market, then the bond market and currency exchange rates. While stock markets throughout the world generally move in the same direction or have a positive correlation.
When there is a global economic crisis, the prices of stocks in various countries will fall. For example, the following is the correlation between the Dow Jones (US) stock index and the Nikkei stock index (Japan).
Some important world stock price indices that need to be considered as the main indicators in the Intermarket analysis are:
- Dow Jones Industrial Average (DJIA, or Dow Jones) – United States
The Dow Jones Index is a leading indicator representing 30 US giant companies such as AT & T, Pfizer, McDonald’s, and others. The Dow Jones Index is always a reference for investors around the world and is an important market sentiment indicator. The Dow index is also sensitive to changes in the global political and economic climate.
- Standard & Poor’s 500 (S & P 500) – United States
The S & P 500 tracks the stock price of 500 large companies in the US. After the Dow Jones index, the S & P is a stock index that is widely traded in the US. At present, the prestige of the S & P 500 is quite high and is used as a reference for fund managers and several US financial institutions such as pension funds and others.
- National Association of Securities Dealers Automated Quotations (NASDAQ) – United States
NASDAQ includes stock prices from 3700 companies in the US, especially companies engaged in technology. Important stock index in the US after the Dow Jones and S & P 500.
- Nikkei – Japan
The Nikkei is the average stock price of 225 major companies in Japan such as Toyota, Japan Airlines, Fuji films, and others. As the main indicator, the prestige of the Nikkei can be said to be equivalent to Dow Jones.
- Deutscher Aktien Index (DAX) – Germany
DAX includes blue chip prices from 30 major companies in Germany such as BMW, Deutsche Bank, and others, which are traded on the Frankfurt Stock Exchange. With the existence of Germany as the largest economy in the Euro area, the DAX stock index has always been a concern of investors.
- Dow Jones Euro Stoxx 50 (Euro Stoxx 50) – Euro Region
Euro Stoxx 50 is a stock price index of 50 major companies in the Euro area from various sectors. This rising stock index was made by Stoxx Limited, an affiliate company between Deutsche Boerse AG, Dow Jones & Company and SIX Swiss Exchange.
- FTSE – UK
FTSE is the stock price index of various major companies traded on the London Stock Exchange. There are several versions depending on the number of companies calculated in the index, for example, FTSE 100 or FTSE 250.
- Hang Seng – Hong Kong
Hang Seng is a stock price index of several large companies in China and Hong Kong, so it is always a reference in the Asian market after the Nikkei stock index. The Hang Seng index is currently managed by HSI Services Limited, a subsidiary of Hang Seng Bank.
Bonds in the Global Financial Market
At present, the bond market (bond) is one of the core parts of the global financial market system, so it is one of the centers of attention of forex traders in the intermarket analysis.
A bond is a proof that investors have agreed to provide a number of loan funds to the government of a country (for government bonds) or a legal entity (for corporate or institutional bonds), with a time limit of return and interest rates determined by the publisher. In this case, the investor is the buyer of the bond, who will receive the repayment of the principal after maturity.
When the bond maturity can be several months to more than 50 years. Interest payments can be made within a certain period of time according to conditions (for example, two or once a year).
Interest paid is a profit obtained by investors, or called bond yield. Because bonds are usually traded on the secondary market, the prices and yields can change.
Changes in bond yields are in line with changes in central bank interest rates. If bank interest rates rise, bond yields rise; and vice versa. If bond yields rise, the bond price will drop as the following illustration (the actual characteristics are not necessarily like images, only as illustrations).
Government bonds/sovereign bonds are always considered the safest investment tool. The only thing that causes a loss in investment in government bonds is if the country’s government goes bankrupt and there is a default. For large countries like the US, Germany or Japan, this is very unlikely. In addition, the yield of government bonds can be used as a predictor of the direction of the state bank’s interest rate policy.
A relationship between Bond Yield and Currency Exchange Rates
Bond yields can be used as an indicator for the capital market. US Bond Yield indicates US capital market conditions, so it also reflects the demand for US dollars. Bank interest rates illustrate the inflation rate. If bank interest rates rise, bond yields rise and bond prices fall. An increase in bank interest rates will cause the currency exchange rate to strengthen.
So increasing bond yields (or falling bond prices) leads to an appreciation in currency exchange rates. This situation can occur in economic conditions with positive (normal) inflation. In a state of economic deflation, there will be a shift or change in relations between the parameters mentioned above
A difference in Yield on Bonds Between Countries
Bond Spread is the difference between bond yields between two countries. This difference or spread can encourage investors to carry trade practices.
Therefore, by always looking at bond spreads and changes in interest rates, we will be able to predict the direction of currency pair movements.
When bond spreads between the two countries widen, the country’s currency with higher bond yields will strengthen against the currencies of countries with lower bond yields. ]
For example, the following is the spread between bonds issued by the governments of Australia and the United States (for a period of 10 years) and the exchange rate of AUD / USD:
When bond spreads rose from 0.5% to 1% from 2002 to 2004, AUD / USD rose almost 50%, from the level of 0.5000 to 0.7000. In 2007, when bond spreads increased from 1% to 2.5%, AUD / USD rose from 0.7000 to around level 0.9000, amounting to approximately 2000 pips.
Main Commodity and Currency
The main type of world commodity that affects currency exchange rates and is important to be observed in the context of Intermarket analysis is gold (gold) and crude oil (crude oil).
The other major currency pairs that have a correlation with gold are the US Dollar vs. the Swiss Franc (USD / CHF). Unlike Australia which is the world’s number two gold producer, the correlation of the Swiss Franc exchange rate against the price of gold is due to the fact that more than 25% of the outstanding Swiss Franc is backed up by the country’s gold reserves. Therefore, CHF has a positive correlation with gold, or USD / CHF and gold have a negative correlation.
On the other hand, the price of gold and US Dollar tends to have a negative correlation. Traditionally, if the global economy is growing, investors tend to buy US Dollars and sell gold; and vice versa.
Crude oil, or often referred to as “black gold” (black gold), is one of the world’s major commodities that greatly affect the world financial market. Industrial energy in the world’s major economies is still heavily dependent on oil.
Therefore, fluctuations in oil prices will have an impact on the variable costs of production and transportation which can ultimately affect the country’s output. Because the price of world crude oil is pegged to the US Dollar, fluctuations in the value of the US Dollar will directly affect the world oil price.
Meanwhile, USD / CAD is the currency pair with the highest correlation with world crude oil prices. CAD exchange rates have a positive correlation with oil prices; so if the oil price rises, the CAD will go up or USD / CAD go down; and vice versa. Following is the correlation between world crude oil prices and USD / CAD between 2000-2011:
Conclusions Regarding the Intermarket Analysis
From some of the previous reviews, as a basis for intermarket analysis in forex trading it can be concluded:
- There is a positive correlation between world stock markets, so if the Dow Jones index falls, it is likely that the Nikkei index will also fall. On the other hand, there is a positive correlation between the stock index and the exchange rate of a country’s currency. If the Nikkei index (Japanese stock index) weakens, then USD / JPY also weakens (JPY strengthens); and vice versa.
- There is a positive correlation between the stock market, bonds, and the exchange rate of a country’s currency. The increase in stock indices and bond yields indicates a higher income prospect that will attract investors in, causing demand for local currencies to increase.
- If the difference in bond yields between the two countries widened, then the national currency with higher bond yields would strengthen against the currencies of countries with lower bond yields.
- If the gold price rises, the US Dollar tends to weaken, AUD / USD and NZD / USD rise (besides because there is a positive correlation between AUD and NZD, New Zealand is also a gold producer), while USD / CHF falls. If the price of gold rises, then the EUR / USD tends to rise. Gold and the Euro are often interpreted as “Anti-Dollar” or assets whose price movements are opposite to the movement of the US Dollar.
- The movement of the US Dollar affects the price of oil. If world crude oil prices rise, USD / CAD falls.
The relationships that can be observed through Intermarket analysis are seen in long-term price movements, so it is useful to be used as an additional consideration during forex trading and provide context when looking at market dynamics
However, positive and negative correlations in the Intermarket analysis are not absolute but can vary depending on whether the economic conditions are healthy or crisis
The application of intermarket analysis in forex trading should be accompanied by observations regarding the conditions of global economic fundamentals.