How the Forex Market Relates to other Markets

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How the Forex Market Relates to other Markets

We will now look at the concept of Intermarket analysis which we devoted some time to in previous sections.

Despite our sole intention of making a profit, we play a much more important role than is commonly thought. We as Speculators provide the market with large amounts of important liquidity and make the market far more efficient for all market participants to trade within.

It’s worth repeating that without Speculators just like us the global financial markets would grind to a complete halt almost overnight. This would cause industry, agriculture, and businesses around the world to fail quickly. This highlights the importance of why we need to take our position as Speculators very seriously. It also helps to prepare us to not have any negative preconceptions such as those that the media puts on us Speculators. Having this understanding can give us the confidence to participate profitably and successfully.

Speculators contribute to all markets and generate price movements across a broad range of asset classes. There are no modern markets where speculators don't play an important role in the overall structure and success of the particular market.

Bonds

If you are interested in financial markets you have no doubt heard of bonds and likely have an idea of what they are.

A bond is simply a form of a loan. For example, you would borrow money from a bank but for a very large company or government, this would be impossible because banks are not in a position to lend such huge amounts of money safely while keeping their books balanced. It would be pretty crazy to think of thousands of companies going to banks and asking them for hundreds of billions of dollars to borrow. Instead of taking a loan from a bank these large governments and companies raise money by splitting that loan between thousands of investors on the open market in the form of a bond.

Any entity offering bonds to an investor is called an issuer. In exchange for this investor money, the government or company will promise to pay the money back at a certain date in the future which is known as the maturity date. They will also pay the investor a rate of interest to make it worth their while for parting with their money. This interest payment is called the coupon.

Bonds are known as fixed income securities because the amount of money the investor will receive at the end of the loan is known in advance and guaranteed by the issuer. The coupon is paid either once or twice per year depending on how the issuer has set up the bond.

At the end of the agreed lending period, the investor receives its original investment amount back. For example, you may buy a bond with a face value of $1,000 that has a maturity of 10 years and a coupon of 8%. This means that you will receive $80 per year for 10 years and then you will get your original $1,000 back at the end of the tenth year.

When purchasing a bond you are essentially purchasing debt in exchange for getting a specific yield.

There are two main types of bonds:

1. Corporate bonds: These are issued by companies to raise money for things such as new plants and materials or to fund expansion projects.
2. Government bonds: These are issued by governments to raise money for things like social programs or infrastructure projects. They could also be raising more money to pay off existing bonds and debt obligations. Many larger first world governments are in a situation where a huge part of their borrowing gores to pay off past debt.

For our purposes, the most important type of bond is a government bond because these are directly influenced by interest rates. This of course ties them in perfectly with FX trading. The entire FX world revolves around interest rates and interest rate expectations for the future of economies.

Because governments are very dependable and stable in most first-world nations the chances of them not paying the coupon or the original face value are relatively low. This makes bonds a low-risk investment. Because bonds are bought and sold on the open market it means that you can buy a bond rather easily but also sell it to another investor at any time before the maturity date if you need to.

Some people get confused about the price of a bond and the yield of the bond. When pricing bonds it’s important to remember that the face value is the price that is returned to the investor at the maturity date. The price of the bond is how much it would cost an investor to buy it from another investor before that maturity date.

When a bond is trading at a price above its face value then it is said to be trading at a premium. Whereas when it's trading below its face value then it's said to be trading at a discount.

The interest coupon can be set at a fixed interest rate that is tied to the face value. For example, if you buy a bond for $1,000 at a fixed rate of 10% you will receive $100 each year no matter what happens to the price of the bond in the markets. In the case of U.S. Treasuries, it can be tied to fluctuating interest rates or indexes. The price of bonds with a lower coupon tends to fluctuate more while the higher coupon bonds tend to be a lot more stable.

The maturity date can be anything from one day to 10 years and sometimes can even be as high as 100 years. This was the case in Mexico in 2015 when they launched the world’s first ever 100-year bond priced in Euros. The length of the maturity will also dictate what price it is because a bond with a 1 year maturity is much more predictable than a bond that matures in 100 years. In general, the longer the time to maturity the higher the interest rate will be.

This all revolves around risk and the higher the perceived risk the higher the coupon will pay to compensate investors for the higher amount of risk they are taking. To help investors navigate these risks there are several special bodies that exist to alert investors of the highest and lowest risk companies and government bonds available. This is aimed to help investors make better decisions on investments based on their own individual risk tolerances.

The three largest credit rating agencies are | Moodys, | Fitch, and | S&P. The market will pay close attention to what these agencies say and how they rate each issuer. They have several rating levels that split each issuer into either investment grade or junk grade. Issuers with a multiple A rating are considered the highest quality to invest with while BBB to single A ratings is still strong.

Anything that has a rating below BBB is considered speculative and much higher risk. These are commonly referred to as junk bonds.

Governments and their bonds that are rated as junk are not necessarily safe and must offer a much higher yield in order to tempt investors to part with their money. The most confusing part of the story of bonds to most traders is that there seem to be so many different prices to measure. So let's try to simplify this.

When you are reading through news articles and news feeds you will often hear analysts talking about something called the yield. The yield is simply the coupon amount divided by the price of the bond. To understand this better we will use an example to explain it. To do this we are going to over-simplify the process slightly but it will give you a good general idea of the point we are trying to get at.

Imagine you buy a bond with a face value of $1,000 and a coupon of 10%. If the price remains $1,000 then the yield is simply $100 per year. However, if the price of the bond goes down to $800 the yield now increases to 12.5% because the coupon payment is based on 10% of the original face value of the bond which was $1,000. This means that you will receive $100 per year on an $800 bond which is obviously higher than 10%. The math works out by taking the $100 original yield and dividing it by the new price of $800 which equals 12.5%.

The reverse is true if the price of the bond goes up instead of down. For example, if the price of the bond goes from the original face value of $1,000 up to $1,200 then the new yield is actually 8.3% because you had to pay more for the bond than the face value.

It's due to this effect that when trying to simplify the relationship between the price of the bond and the yield of the bond we can say that when the price of the bond goes up the yield goes down and when the price of the bond goes down the yield goes up.

If you are in the market for buying bonds your primary concern is gaining a high yield but if you are a bondholder and already have your yield locked in then you would like to see the price of the bonds increase so that you can have the option of cashing out for a much bigger profit later on. There is nothing better to a bond trader than getting a nice yield for a while and then cashing in on a profit for a higher face value.

The primary thing that we need to appreciate when thinking about bonds is the relationship with interest rates because they are just as important to bond markets as they are to FX markets. When interest rates rise the price of bonds in the markets fall. This raises the yield of older bonds to bring them into line with the new bonds that are being issued with higher coupons.

When interest rates fall the price of the bonds rise which lowers the yield of older bonds to bring them into line with newer bonds being issued with lower coupons. That’s why bonds are so affected by interest rate adjustments by Central banks. These rate adjustments also increase the speculation around bonds which causes plenty of price volatility.

There are 3 types of government bonds:

1. Bills: These mature in less than one year.
2. Notes: These mature between 1-10 years.
3. Bonds: These mature longer than 10 years.

All of these marketable securities issued by the U.S. government are collectively known as treasuries. This makes the three types of bonds listed previously referred to as treasury bills, treasury notes, and treasury bonds.

US bonds are widely watched in the markets because they are regarded as the safest form of investment available. This is because they are issued directly by the U.S. government. These bonds or treasuries are also known as the risk free rate because they are considered to be free from risk. It's not to say that the U.S. government can never default on its debt obligations but the market regards this as so unlikely that they are willing to call U.S. treasuries the risk free rate.

Other first-world governments are regarded as being extremely safe. For example, the United Kingdom has never defaulted on its debt in its very long history on the global financial scene.

Because of the secure nature of bonds, and the fact that they can provide a guaranteed payout, they are extremely popular with large investment and pension funds around the world that are looking to ensure growth and income in the safest way possible.

Bond markets relate to FX on two main levels:

1. They have a co-dependency on interest rate fluctuations and speculation: This means that by watching the bond markets we can sometimes get clues as to whether or not similar moves may happen in FX.
2. The demand produced by attractive bond yield: For example, during times of increased risks, or low domestic yields, large funds may decide to invest in the bonds of a foreign government. An example of this is when a UK pension fund decides to buy some US treasuries in order to protect them from being overly exposed to UK assets. To do this they first need to buy U.S. dollars and sell their British pounds in exchange. This means that in order to trade the bond market they must first trade in the FX market. In very large volumes this can have a temporary impact on the price of various currency pairs which is why it's important for us to be aware of it.

Commodities

So when we say commodities what are we actually referring to? Basically, commodities are raw products that typically come from nature. For our purposes here we are only going to talk about commodities that can be bought or sold on an exchange. There are loads of different types of commodities being traded in the financial markets from oil, gold, corn, milk, wheat, and so on.

As with most markets, the bulk of volume comes from us speculative traders who are simply betting on the price of the commodity going up or down. But as we have previously looked at, this type of speculative activity provides the commodity markets with much better prices to buy and sell from. People and companies, such as farmers and industrial producers rely heavily on there being adequate liquidity so that their businesses function smoothly.

Traders most commonly trade commodities via a futures contract. Commodities can be traded via a host of different instruments such as spot prices, options, ETFs, etc.

There are many different types of commodities all traded individually from one another. This trading is based on external factors such as supply and demand. However, the relationship between certain commodities and currencies is mainly based on how much of an impact the price movements on the commodities will impact the overall economic performance of the nation producing or importing them.

Let's use the Canadian dollar to demonstrate this. Canada is a major producer of oil and it’s one of the country’s largest exported products. So if the price of oil falls significantly over a sustained period of time then eventually this will start to reduce the amount of money that Canada makes on its oil. This will ultimately start negatively affecting economic data figures such as GDP and other growth metrics within Canada. If the economy stagnates and inflation starts falling then the Bank of Canada may be forced to cut its interest rates which in turn will cause the currency to devalue. This is why the price of oil is of great concern to traders holding Canadian dollars. Traders want to know what is happening in the oil markets and the reasons why so they can determine how much of an impact it will have on the future value of the Canadian dollar.

When it comes to FX the key to understanding the correlation to commodity prices lies in two key areas:

1. Knowing which countries have heavy dependencies on either selling or buying commodities.
2. Being tuned into how much focus the market is giving to moves on those commodities at any given time.

The truth is that commodity prices move around every day but not all of these moves will impact FX prices. This is because they may not cause the market to have any fears or hopes about the longer-term impact on the country’s economy.

For example, if oil prices] fall hard in a single session because of some kind of announcement from | OPEC, this may not necessarily cause any large moves on the Canadian dollar. However, if oil moves in a strong downtrend and the market feels there is a very good fundamental reason for this to continue then this could lead to more concern from the FX market as the uncertainty of that could lead to panic selling of the Canadian dollar. This panic selling could lead to more aggressive selling if there is negative data coming out of Canada as a result of the price move lower in oil. This will in term affect inflation negatively which is going to concern the Bank of Canada who may be forced to take action. This might lead to the market Speculating on an interest rate cut before the [Central banks] is prepared to announce a cut.

It's worth mentioning again that the speculation around interest rate cuts is just as important, if not more important than the interest rate cut itself. This is a really important point. The expectations of a risk event are just as, if not more, important than the actual risk event when it happens.

The same principles apply Australian dollar. It’s a huge exporter of iron ore and copper. If the prices in these commodities change over time it could have both a negative or positive effect on the price of the Australian dollar.

Another example is that of New Zealand which is a large exporter of dairy. Dairy makes up a big chunk of New Zealand’s GDP. So if we have changing dairy prices over time this too could have a positive or negative effect on the price of the Kiwi.

The key is not just to watch the commodity chart or try and trade a correlation, but to tune into the market’s reaction so that you can gauge how seriously the reasons for the move are being taken by the market and what the expected impact could be on the nation’s economy.

The main reason traders get confused when trying to conduct Intermarket analysis is that they try and interpret each move as a fixed rule. They get trapped into thinking that if oil goes up then the Canadian dollar must go up as well. The reality is that most of the time the markets might not even bat an eyelid at oil prices. But then all of a sudden the market becomes obsessed with oil causing the Canadian dollar and oil to become very closely correlated. This will happen until the market forgets about it and moves on to the next major concern or market hype.

Just remember that the market is made of people and people can be fickle and irrational. This is why it’s important for you to keep an eye on commodity prices and how they relate to certain currencies. However, most of your analysis should be news and sentiment based rather than price.

Equities

Equities are securities such as stocks or shares of companies from around the world. Traders use the stock market to gauge how well overall market participants are expecting the economy of that particular nation to perform. If the market is expecting the economy to do well and the growth to accelerate then the stock market will generally rally and push higher. This is also true if the market is expecting the nation’s outlook to be weak as the market will sell the companies within the nation’s indexes. At its most basic form, some economists define a strong economy as having a strong stock market.

As with commodities, this is not an exact science and most of the time the FX markets will trade off its own issues leaving stocks to move in their own way. At other times the Forex market will become obsessed with something happening in the equities market.

For example, maybe there is a big sell-off in a country’s stock market. If the selloff gets out of control this will likely creep over into to FX markets. When traders in the FX market get concerned they buy up safe haven currencies and sell off currencies that are considered to have more risk. This is exactly the type of scenario that tends to occur to bring both of these markets into the spotlight at the same time. A good example is when the stock market goes completely risk off because of some sort of major concern. This will cause safe haven currencies to benefit as traders look for safety.

Stocks can also be impacted by FX. For example, if a company has many offices or manufacturing plants around the world then they will need to buy the local currency in those countries in order to pay their staff in those different countries. If the price of the local currency rises faster than the company’s home currency this could cause the company's profits to fall because it’s costing them too much to buy the local currency. This will negatively impact the profit performance of the stocks in question.

Also, if these transactions that companies make are large enough they can have a limited impact on currency prices in the short term as they sell their home currency to buy the foreign currency.

Another thing that could impact a company is if a central bank implements a sustained campaign of dovish behaviour leading to the depreciation of its currency over a period of months or years. This can impact the future earning potential of companies that export a lot of products abroad. The depreciation of the currency can give those exporting companies a more competitive edge because the cost of developing their goods is now less and continuing to fall. This potentially means more profits and higher dividends leading to a higher share price.

As you can see, all markets can be interrelated on many levels and one does not always lead the other and none of them are necessarily related at all. However, when the market has a concern or an idea in its mind the correlations can be very powerful and lead to some excellent trading opportunities.

The main point of this section is to introduce you to the concept of Intermarket analysis but also to stop you from getting overly caught up in the rules of how each market is connected. The best thing to do is to mostly focus on using the market’s reaction to tell you when you should be focused on a particular correlation.

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