Understanding the relationships between stocks, bonds, commodities, and currencies can help you identify economic trends and better manage your investments.
Recognize when relationships between asset classes appear to be broken
It’s all about relationships, even in the financial markets. One of the many approaches to analyzing financial markets is intermarket analysis, which looks at the relationships between stocks, bonds, commodities, and currencies of global markets.
Understanding the relationships between these markets can help identify economic trends, investment cycles, and risk rotation. And that can help spawn broader trading ideas, reveal potential market turning points, or confirm other analysis methods. Intermarket analysis can be an important piece of a diverse investing approach. Of course, diversification doesn’t ensure investing success or prevent losses. You might participate in big market moves in places you might’ve otherwise ignored or hop on trends because you anticipate a ripple effect.
Here are some traditional intermarket relationships:
The U.S. dollar is tied to many commodities, such as crude oil and gold, primarily because most commodities are bought and sold with dollars. Historically, there’s an inverse correlation between the dollar and commodities. Take crude oil as an example. It’s always priced in U.S. dollars—if the dollar is stronger relative to other currencies, you’ll need fewer dollars to pay for a barrel of oil. If the dollar is weaker, you’ll need more dollars to pay for that barrel of oil. Because of this, oil prices are inversely correlated with the value of the U.S. dollar (see figure 1).
FIGURE 1: GOING SEPARATE WAYS. This three-year weekly chart shows the inverse relationship between the U.S. dollar ($DXY—candlestick) and crude oil futures (/CL—purple line). Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
Whether you’re a long-term investor or a short-term trader, intermarket analysis can help you identify bigger economic cycles or potential short-term trading spots. Long-term investors may take a macroeconomic approach to intermarket analysis, making broad asset allocation decisions based on trends among asset classes.
When trading commodity futures on a multi-day to multi-week basis, many short-term traders may try to take advantage of the volatility created when asset classes are at their extremes.
When it comes to market extremes, however, longer-term investors may be best served by having patience and waiting for confirmation of a trend change before acting upon expected correlations.
By traditional definition, bond and stock prices normally trend in the same direction, according to John J. Murphy in his book Intermarket Analysis. So far, that’s been true of recent market conditions. Since the S&P 500 Index (SPX) hit a low in March 2020 due to the COVID-19 pandemic, it has climbed and hit record highs. During the same period, bond yields drifted sideways and moved higher from August 2020, although they stalled and reverted to a sideways movement.
But unusual patterns can be the most telling for investors. As bond traders position for higher Fed rates, they’ll drive prices lower and yields—aka market interest rates—higher. Could this potentially hurt stocks? How soon? And which groups in particular would be hurt?
We’ve seen some of that play out this year. In March, the 10-year Treasury yield rose above 1.7% likely because of inflation fears. But they’ve fallen since then, dipping as low as 1.128% as uncertainty about potential economic growth crept in.
Bond yield changes can affect markets—commodities and the U.S. dollar are likely to move, which can eventually weigh on stocks. For this reason, investors should keep an eye on the bond markets.
The Federal Reserve keeps calling inflation “transitory.” The question is how long transitory might last. In September 2020, the Fed stated it would most likely not raise rates till 2023. If the Fed were to raise interest rates earlier than 2023, what impact would it have on the stock market? And how could intermarket analysis help investors prepare for such changes?
Bond prices, of course, have an inverse relationship to their yields, which simply means that as bond prices rise, interest rates (or yields) fall and vice-versa. The traditional line of thought is that falling interest rates are stock positive because businesses can borrow more cheaply to expand. Conversely, rising rates are traditionally seen as negative for stocks, particularly if rates climb so much or so fast that they choke off economic growth. Murphy wrote that bonds peak and fall ahead of the stock market, acting as a leading indicator for stocks at cycle turning points.
Bullish stock investors can take heart in research that reveals a rising interest rate environment doesn’t necessarily signal doom for stocks. That holds true especially in the early part of a rising interest rate cycle, which is typically seen during strong economic growth periods that generally lead to increased corporate earnings.
In the early stages of an interest rate hiking cycle, stocks still have the potential to continue to climb because the higher rates likely reflect stronger economic growth. But the stock and interest rate relationship can change in the short term. We experienced this during the COVID-19 crash when the SPX and the 10-year Treasury yield both fell (see figure 2).
FIGURE 2: A SHORT-TERM RELATIONSHIP. Yields and equities fell together during the pandemic crash, but equities recovered while yield stayed lower. Chart source: The thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.
It might be, given that we have an economy recovering from a pandemic. Higher-than-expected inflation and the Fed’s rising rates are two unknown variables. We’ve seen commodity prices rise this year, and although prices have pulled back for some of those commodities—copper and lumber, to name a few—signs of inflation still loom. Oil prices and the consumer price index continue to rise, and bond markets still show uncertainty.
Of course, past performance is not a guarantee of the future, but If history is a guide, the bond market and the level of the 10-year yield could be an important catalyst for the long-term stock market trend in the months ahead. Although correlations between asset classes don’t necessarily provide trading signals, observing the relationships can form the basis of your trading decisions. Intermarket relations, while important, don’t always “follow the textbook” in terms of what they do. At times they zig when you expect them to zag.
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