Intermarket analysis and its edge in FX
For those of you recently finding your way into the FX world, there is one key aspect of currency trading that you may have not looked at yet, namely the relationship of other markets to the world of FX. It is called intermarket analysis and understanding it can provide good FX trading opportunities. This article will serve as an introduction to learn how the bond, commodity, and equity markets impact currencies.
- Firstly, what are bonds?
A bond is simply a type of loan. If you or I want to borrow some money, we might go to a bank. However, when Governments and very large companies want to borrow money, they can’t easily go to a bank because of the huge amounts of money involved. The solution, in this case, is a bond. This provides the mechanism by which a Government or large corporation borrows money for their needs. During the lifetime of the bond, the lender will receive regular interest payments in return for lending the money. These interest payments are paid bi-annually and they are fixed when you initially purchase the bond. So, for example, if you purchased a UK bond (Gilt) for 1000 GBP with a coupon of 5% you would receive a total of £50 for each year of the bond and then receive the 1000GBP back when the bond expires. Government bonds are called ‘gilts’ in the UK and ‘treasuries’ in the US. Company issues bonds and they are called ‘corporate bonds’. Bond markets and currencies are both deeply impacted by interest rates. One key relationship to grasp is that the value of bonds typically falls when interest rates rise. So, the longer the bond has until maturity, the greater the risk of fluctuation in price. A one-hundred-year bond could have huge changes in price before it is finally set to mature.
- How do the bond markets impact currencies?
The general rule of thumb is that rising bond yields are positive for a currency. The exception to the general rule is that when a country is perceived as being at a greater risk of defaulting on a debt, the bond yields rise to attract investment. This makes sense as an investor wants a greater rate of return to offset the greater risk the investor is taking. A good example of this was the rise in Italian 10 Year bonds in 2018, which saw yields rising and the Euro depreciating. Each spike in the Italian bond yields was a good opportunity to sell the Euro. See the chart below:
The general rule of thumb to know is this:
Rising bond yields = positive for the currency (unless a country is in financial distress)
Falling bond yields = negative for the currency
- What are Equities?
Equities are stocks and shares of companies. When you buy equities, you are buying partial ownership of a company. Equities are regarded as more risky assets than say Government bonds. As a result, equities offer a higher rate of return than Government bonds in order to reflect the greater risk the investor is taking on.
- Equity markets serve as good indicators of risk
Equity markets are very sensitive to risk, so currency traders take their lead on risk from these markets. Knowing this can provide some good opportunities to take advantage of. In times of market uncertainty and risk, investors rotate out of equities and into other instruments like bonds. When this risk aversion takes place, we tend to see safe-haven currencies like the JPY and the CHF appreciate. We saw that when President Trump announced a further 10% tariffs on the rest of the $300bln of Chinese goods to the US. Conversely, when investors are feeling positive, they move back into riskier assets like stocks. This is called risk-on sentiment. In this scenario, high beta currencies like Aussie and Kiwi dollar appreciate. The general rule to know is this:
Rising equities = Risk-on sentiment (AUD and NZD strength)
Falling equities = Risk-off sentiment (JPY and CHF strength)
Certain economies are highly dependent on commodity prices. Any move in commodity prices will impact that countries currency. Here are some examples:
Canada is one of the largest oil producers in the world with oil reserves contained within its oil sands. According to the Oil and Gas Journal, Canada has around 173 billion barrels of proven oil reserves and, at the start of 2015, these reserves were ranked third largest in the world. Canada is also the third-largest exporter of Oil with around 99% of exports going to its fuel-guzzling neighbour, the US. So, the price of oil has a big impact on CAD. A surge in Oil prices will cause the CAD to rise with it. Likewise, a fall in oil prices will cause the CAD to fall.
Australia mines a considerable amount of Gold. A rise in Gold prices causes AUD to rise and vice versa. New Zealand too has an abundance of natural resources and its significant agricultural presence is what attracts the label as a commodity currency label. Unlike the AUD and CAD, the NZD is not tied to one particular commodity. Instead, the currency is impacted by a number of different commodities.
So there you have it, the impact of intermarket analysis on currencies. After some time this will become second nature to you. However, before it does, may I suggest that you write down some notes to keep by your desk until you have internalised these basic relationships. Knowing when they apply will not only keep you out of the wrong trades but will also help get you into the right ones.