19 October 2023
Intermarket Analysis for Forex Trading
Intermarket analysis is quite a common concept in forex trading. It is a departure from other forms of market analysis that rely mainly on a single-market approach.
Today’s economy is highly globalized, contributing to the interconnectedness and interdependence of various financial markets worldwide. Shifts in prices and trends in one market may influence the other markets’ direction.
As the 21st-century global economy grows and new inventions are adopted, the financial markets will become even more sophisticated. What does this mean? The central role of these markets in the international scene will be more evident.
This is a call for traders to explore the concept of intermarket analysis and the techniques available to help them implement the strategy efficiently. It is also up to the trader to keep up-to-date with these changing market dynamics to continue making profits.
What is Intermarket Analysis?
This is an evaluation method that focuses on market correlation. It studies the relationships between different asset classes in the financial markets to obtain insights into potential movements and trends. The analysis also gauges the asset class’s strengths or weaknesses. Let's delve into the details of the concept below:
The Four Major Markets
One of the key markets assessed is the bond market. It involves the buying and selling of debt instruments by governments [KY1] and corporations. Bonds are generally issued to raise debt to finance operations or look for growth opportunities.
Issuers pay back the initial investment coupled with interest at a specified time. Fluctuations in the market affect interest rates and investment choices, impacting broader economic trends and financial conditions.
The commodity markets are also analyzed. The market provides a platform for trading raw materials or physical products, such as precious metals, agricultural goods, energy resources, etc., on specialized exchanges as financial assets. It's also possible to purchase contracts (e.g., futures, forwards, and options) on these commodities, thanks to the well-established derivatives markets.
Investors are usually advised to acquire at least a small part of a well-diversified commodity portfolio. This is because their correlation with other financial assets is usually not high and may act as a hedge against inflation. Price changes in the commodities market impact inflation, industries, and nations' economies that rely on commodity consumption or production.
The other primary market included in the intermarket analysis is the stock market, where investors trade publicly held company shares through formal exchanges. It also features over-the-counter (OTC) marketplaces where traders buy and sell directly with each other under a defined set of rules. Stock markets act as a barometer for the general economy and allow traders to discover the price of shares of different companies.
Last on this list of markets is the currency market, also known as the foreign exchange market. It involves trading currencies by various participants operating in different jurisdictions globally. The most unique thing about this market is that it doesn't have a central marketplace, so all transactions are conducted via computer networks rather than on a centralized exchange.
The Importance in Forex Trading
Forex trading is not only a complex and fast-paced activity but also risky, so you need every help you can get to succeed and maintain a winning streak. Intermarket analysis has become essential for traders who want to understand the financial markets better.
It offers valuable insights into the connections of various markets and factors influencing the values of currencies. As a result, you can make more informed decisions as an investor.
The analysis can also help you spot emerging trends across various asset classes. For instance, if a commodity such as oil is experiencing a substantial rally, it could signify that currencies from oil-importing nations are weakening. You may then use this information to adjust your trading strategies.
Do you want to confirm trends in the forex market? Consider using intermarket analysis as it can tell you how changes in one market correspond with the other. Let's say the value of a currency is increasing in the forex market, and the local stock market is recording gains.
This correlation confirms an upward trend, and you gain more confidence in your trading decisions as a trader. By bolstering the accuracy of your forecasts, intermarket analysis enables you to make calculated moves and improve your trading outcomes.
Identifying changes that can affect your investments early enough is another perk of using intermarket analysis. An abrupt increase in commodity prices, for example, could signify possible inflation that impacts bond yields and, ultimately, currency prices. When you see these patterns, you can expect specific market shifts and act early to protect your investments and avert losses.
Did you know that intermarket analysis can aid you in risk management? Knowing how the different markets relate makes you better positioned to expand your portfolio and spread risks. So, you can counteract losses in one market with profits in another, especially during unfavourable periods.
Say you are trading forex, and an unexpected event occurs, causing the value of the currencies you are trading to spiral downward. If you have invested your money in uncorrelated markets like commodities and bonds, it can decrease prospective losses.
Furthermore, by taking the broader market context, intermarket analysis allows you to gauge the general market sentiment and modify your positions in forex as needed. This helps reduce the risk of ending up on the wrong market side because of unexpected sentiment movements or correlated market shifts.
Understanding Market Correlations
As noted earlier, the financial markets are just one sizeable, interconnected web where the behaviour of one affects the other positively or negatively. In that regard, learn how the forex market correlates with the bonds and commodity markets below:
Forex and Bonds
There is a strong correlation between the forex and bonds market. The bond market is often the leading indicator of currency movements and vice versa.
Generally, currency prices and bond yields (returns gained from bonds) are positively correlated. When a specific bond yield is higher compared to other assets, investors are drawn to purchase these bonds using the local currency. This leads to an increase in demand for the currency and, consequently, a rise in the currency's value.
On the contrary, if the bond yields are lower, there's a decreased foreign capital inflow. This is because investors are reluctant to put their money where they believe they will not obtain significant gains. So, the demand for the local currency reduces, potentially causing it to depreciate.
It is important to note that interest rates also affect a currency's price due to the demand for purchasing bonds using that currency. Countries providing higher interest rates tend to draw more investors in their bonds as they want to earn higher yields.
The demand for the currency required to purchase those bonds makes it stronger. The reverse is true for nations offering low-interest rates.
Forex and Commodities
Commodity currencies (pairs from nations with massive commodity reserve amounts) have correlations with commodity prices with considerable influence on national economies. These price correlations can be positive or negative and significantly impact currency movements.
Let's take the case of the US dollar and gold prices. The correlation is primarily negative, such that when the dollar value goes up relative to other currencies globally, the price of gold reduces. This is because gold becomes costly in other currencies, lowering its demand.
On the other hand, when the US dollar price goes down, gold's value tends to increase as it becomes cheaper in other currencies. As a result, its demand rises.
Looking at another example, the Canadian dollar (CAD) positively correlates with oil prices, meaning they are likely to move in a similar direction. This is because Canada is one of the largest exporters of oil. Therefore, its economy relies heavily on oil-related revenues, directly affecting CAD's value.
High oil prices generate more revenue for Canada, increasing the demand for the CAD and its value. In contrast, reduced oil prices diminish the country's earning prospects and weaken the currency.
Advanced Techniques in Intermarket Analysis
You can use several advanced techniques to conduct intermarket analysis in forex trading. Some of them include:
These models use mathematical and statistical techniques to study intermarket relationships and forecast possible trends. This enables traders to make data-driven trading decisions to optimize gains. Examples of the quantitative models you may find helpful are:
The Vector Autoregression (VAR) model: It assesses historical data to identify the relationships that exist between bond yields, currencies, stock indices, and commodity prices. Then, it tells you the effects of one market on another.
If, for example, the movement of a currency influences bond yields and stock prices, the model will quantify their connections. So, you will know how to trade to enhance your income.
Time Series Analysis (ARIMA): This statistical technique relies on historical information to spot patterns in the four major markets and uses them to predict trends and prospective changes. A good example is when it identifies repetitive patterns in stock or currency prices and utilizes them to forecast future behaviour. This can aid you in anticipating how the market will behave and improve your decision-making and strategy development.
Factor models: These compare two or more aspects to assess relationships between variables in the market and the resulting performance. For instance, regarding commodity, forex, and bond markets, this model may focus on economic indicators, interest rate differentials, and inflation rates. The main aim is to determine how the factors collectively affect markets and explain the reason behind price fluctuations.
Using Intermarket Analysis for Portfolio Diversification
A diversified portfolio is essential as it decreases your overall risk by spreading your risk across different classes of assets. Working with an intermarket strategy is a good idea to help you move holdings from one sector to another to escape preventable economic downturns. So, how do you implement an intermarket analysis to diversify your portfolio?
Use assets that have low or negative correlations. This means that the relationships between price movements are either minimal or move completely in opposite directions. This ensures that losses in one investment could be offset in another asset.
In this case, investing in US dollars and gold would be ideal—gold’s price increases when the dollar’s value reduces as a hedge against currency depreciation. Also, consider investing in stock indexes when trading currency pairs. If the former declines, the currencies' value may rise, shielding you from more losses.
Engage in factor-based investing. This entails ensuring that your portfolio integrates aspects like growth, value, or momentum relevant across different asset classes. For example, if you select a value-based approach, you can work with undervalued bonds, stocks, and currencies to spread risk.
Analyze the market to identify changes in sentiment. You may have noticed investors shift to safer assets like gold during economic uncertainty. There are also periods where traders work with higher-risk assets to try to get bigger returns.
When you notice these changes, you should modify your portfolio weightings to go hand in hand with the prevailing market dynamics. Ideally, invest in stocks when investors have a high appetite for risk and allocate more to bonds when traders shift their focus to safer assets. This way, you can optimize the performance of your portfolio.
Remember to monitor the markets regularly because correlations may change. With time, assets that previously had a negative correlation may begin moving in the same direction and vice versa. In such a case, you must rebalance your portfolio to manage risks and attain your investment goals.
Case Studies and Practical Tips
Intermarket analysis is not just a theory. People have and continue to use it successfully. Check out some success stories below and the limitations of the strategy:
Intermarket Analysis Success Stories
For years, traders have used intermarket analysis when trading the Japanese Yen and the stock market during periods of market uncertainty. This can be attributed to the Yen's ability to appreciate because of its safe-haven status.
For instance, when the COVID-19 pandemic struck, the global market turmoil made many investors expect its value to appreciate. They also realised the stock market was plummeting as they monitored correlations between the currency and stock indices. They anticipated the Yen to record gains and acted accordingly to benefit from the changes.
Another good example of an intermarket analysis success story has to do with the 2014-2015 oil crash. Traders who comprehended the strong correlation between the CAD and oil prices shorted the currency. Consequently, they could profit from CAD's decline when oil revenues for Canada were reduced.
Intermarket analysis also assisted traders in shielding themselves from the adverse effects of Brexit. The events culminating in the exit showed that it would lead to market turbulence and increase the volatility of the British pound. Wanting to leverage their knowledge of intermarket analysis, wise traders diversified their portfolios by investing in other markets to protect their investments.
Caveats and Limitations
Although intermarket analysis is beneficial, it has its fair share of limitations, which include:
Complexity: Trying to find the relationships between different markets and interpreting related data is not easy, especially for beginner traders. The process requires a deep understanding of the markets, which can take time.
Shifting correlations: Correlations between markets may change from time to time due to certain economic conditions or geopolitical events. So, there's a possibility of making wrong predictions that can harm your investments.
Data availability and quality: Traders may be unable to access the latest market data. This negatively impacts the accuracy of the analysis.
Clashing signals: The analysis can generate conflicting signals from various markets. As a result, traders may experience challenges in making trading decisions.
Subjectivity: More often than not, investors interpret the market relationships subjectively, leading to variations in conclusions.
False signals: Correlations don't always mean that the behaviour of one market affects the other. In this case, if two markets are strongly related, there is no guarantee that changes in one will always impact the other.
Noise in the market: At times, noise and short-term price changes may conceal long-term intermarket trends. This may cause misleading signals that can eventually hurt traders' investments.
Conclusion and Future Implications
Studying intermarket relationships for forex traders is a worthy endeavour. Not only does it help you know how the movement of currencies is affected by other markets, but it also allows you to adjust your strategies to optimize profits. Furthermore, if you capitalize on the intermarket analysis tools, you stand to benefit even more.
Like any other forex trading strategy, this approach has its drawbacks. The good news is that you can minimize their effects by adapting to changing correlations and implementing a robust risk management approach.
The intermarket analysis will continue to evolve as technology advances. Algorithms and artificial intelligence (AI) will likely play a more significant role in evaluating data and spotting correlations. There's also a possibility of the analysis broadening to integrate more assets like derivatives and investments.
Disclaimer: Any information presented is for general education and informational purposes hence, not intended to be and does not constitute investment or trading or tax advice or recommendation. No opinion given in the material constitutes a recommendation by M4Markets that any particular investment, security, transaction or investment strategy is suitable for any specific person.
It does not take into account your personal circumstances or objectives. Any information relating to past performance of an investment does not necessarily guarantee future performance.
Trinota Markets (Global) Limited does not give warranty as to the accuracy and completeness of this information.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 79% of retail investor accounts lose money when trading CFDs with this provider.