Markets are interlinked

The proper course of action is to use traditional technical analysis market by market, and then expand outward to other markets, taking into account their intermarket relationships. When the data have been colleted, the technical analyst needs to see if the individual market conclusions make sense in relation to the intermarket view. If, based on intermarket information, we see an unusual relationship between two markets, we would examine the conclusions derived for the individual markets.

The technical analyst can apply his or her skills to each market separately and without being an expert on any one individual market make intermarket comparisons and develop relationships.

Intermarket analysis requires more information than traditional technical analysis and is therefore harder, but the extra information gained is well worth the effort.

Bonds and Commodity Prices

The relationship between bonds and commodity prices is one of the most important relationships in the intermarket area. The inverse relationship (see Figure 1) between Treasury-bond prices and the commodity markets (represented by the Commodity Research Bureau Futures Price Index) shows the connection between the financial sector and the commodity sector that in effect shows a tie between the stock market and the commodity markets. The stock market is greatly affected by the price of Treasury bonds, and stock and bond prices are influenced by the price of the dollar. The U.S. dollar's influence on stocks and bonds finds its origin in the commodity sector. Commodity prices affect bonds, which in turn affect stocks.

Commodity prices are important to watch because they are the major indicator of inflation. In general, when commodity prices rise, we experience inflation; when they fall, inflation is not an issue. Though commodity markets usually move in the opposite direction to bond prices, they move in the same direction as Treasury bond yields. Since the early 1970s every significant turn in long-term interest rates has been paralleled by a shift in the same direction in commodity markets. (We must remember that bond prices and bond yields move in opposing directions.)

Through intermarket analysis we examine these relationship in a little more depth. During a period of inflation, when Treasury bond yields are rising, bond prices will be on the decline. During a period of disinflation, when bond yields are falling, the price of bonds will be rising. The inverse relationship between commodity prices and bond prices can be documented. If we know that bond prices and bond yields move in opposing directions and that commodity prices and interest rate yields head in the same direction, then we can establish that commodity prices and bond prices move in opposite directions. These relationships do exist, and the importance of being technically proficient in analysing on an intermarket basis is critical for traders and others. In summary, technical analysis of either commodities or bonds would not be complete without a similar technical analysis of the other.

Figure 1 - Bonds Versus CRB Index

(Source: Knight Ridder's Tradecenter. Tradecenter is a registered trademark of
Knight Ridder's Financial Information.)

Stocks and Bonds

There is a strong positive relationship between stocks and bonds. The stock market is influenced by interest rates and the way inflation is headed. Usually, falling interest rates are bullish on stocks (prices rising) and rising interest rates make stock prices go down. The technical analyst should be watching the way stocks and bonds behave in relationship to each other. If they are moving together in the same direction, the analyst should not be worried. If they are moving in opposite directions, there should be an investigation as to the reasons why.

Normally, the bond market moves before the stock market. When the stock market is at its peak, the bond market will usually drop first; when the stock market is at its low, the bond market will head upwards first. The conclusion that we can draw from this is that the bond market is a good technical indicator of what the stock market will be doing.

Stocks and bonds have always been tied together by technical analysts and market watchers. An analysis of one without the other would be inadequate. A prudent stock market investor should always be monitoring changes in the bond market. Bond market changes should always be infused into stock market analysis. A technical analysis that is bullish for bonds will also be bullish for stocks and a bearish technical analysis for bonds will be a bearish indicator for stocks.

The business cycle is an important factor in the discussion of stocks and bonds as it relates to periods of expansion and recession. The bond market is usually a strong indicator of the US economy. A weak bond market commonly indicates an economic downturn and a rising bond market indicates an economic surge. Generally, the stock market weakens during an economic drop and benefits from economic expansion.

Although the preceding facts are usually true, there are some differences. A falling bond market is mostly bearish for stocks, but a rising bond market does not always signify a strong equity market, While a rising bond market does not assure a bull market in stocks, a bull market in equities is improbable without a rising bond market.

The Dollar and Commodities

When analysing the four sectors of the economy, the path to take is to start with the dollar, move into the commodity market, then the bond market, and finally the stock market. The connection of the dollar to stocks and bonds is more complete and makes more sense when analysed through the commodity markets.

We can see this if we begin with the stock market and work backwards toward the dollar. The stock market is reactive to interest rates and thus movements in the bond market. The bond market is shaped by expectations of inflation, which are determined by trends in the commodity markets. The inflationary impact of the commodity markets is usually determined by the movement of the US dollar. Thus intermarket analysis should begin with an analysis of the dollar.

A rising dollar has no effect on inflation. A rising dollar usually produces commodity prices that are lower. A fall in commodity prices leads to higher bond prices and lower interest rates. A falling dollar has the converse effect: it is bearish for bonds and equities and bullish for commodities. Thus we can see that the US dollar moves inversely to commodity prices (see Figures 2 and 3).

Figure 2 - U.S. Dollar Index Versus CRB Index: 1985-1989

(Source: Knight Ridder's Tradecenter. Tradecenter is a registered trademark of
Knight Ridder's Financial Information.)

Figure 3 - U.S. Dollar Index Versus CRB Index: 1988-1989

(Source: Knight Ridder's Tradecenter. Tradecenter is a registered trademark of
Knight Ridder's Financial Information.)

Figures 2 and 3 bring to light some significant facts:

1. A declining dollar is bullish for the CRB index.
2. A rising dollar is bearish for the CRB index.
3. Turns in the dollar happen before turns in the CRB index.

Commodity prices are a leading indicator of inflation, and movements in the US dollar can be used to forecast changes in the CRB index. In the past 28 years every significant turn in the CRB index has been preceded by a turn in the US dollar.

When analysing these two markets, we need to look at the problem of lead and lag times. We know that turns in the CRB index are preceded by turns in the dollar. If we look at the preceding charts we will see that the peak in the 1985-dollar occurred approximately 18 moths before the 1986 fall in the CRB index.

We need a quicker way to predict the impact of the dollar on the commodity markets. Luckily, we can look to the gold market, another step in our intermarket analysis. Of the more than 20 commodity markets that make up the CRB index, gold is the most reactive to changes in the dollar (see Figure 4). A change in the dollar will quickly produce an opposite change in gold, in turn affecting the general commodity price level.

Figure 4 - U.S. Dollar Index Versus Gold: 1988-1989

(Source: Knight Ridder's Tradecenter. Tradecenter is a registered
trademark of Knight Ridder's Financial Information.)

Major upturns and downturns in the gold market lead those same upturns and downturns in the CRB index. Thus, the lead-time between movement in the dollar and the CRB index can be better understood by using the gold market as a link. Gold usually precedes turns in the CRB index by an average of four months.

In summary, there is a direct relationship between the U.S. dollar and the CRB index that will affect stocks and bonds. The falling dollar forces the CRB index higher, and the rising dollar pushes the CRB index lower. Since gold trends in the opposite direction of the US dollar, it establishes a link between the CRB index and the US dollar.

The Dollar, Stocks, and Interest Rates

A declining dollar ultimately pushes interest rates higher, rising interest rates make the dollar more desirable in relation to other currencies and pulls the dollar higher. The rising dollar eventually moves interest rates lower and lower interest rates make the US dollar less desirable in relation to other currencies, which pulls the dollar lower.

The relationship between the dollar and bonds is easy to see. A declining dollar will push bond prices lower and interest rate higher, and a rising dollar will push bonds prices higher and interest rates lower, impacting the stock market.

The US dollar is more reactive to changes in short-term rates than in long-term rates. Long-term rates are based on long-range expectations for inflationary measures. Because short-term rates respond faster to changes in monetary policy, they are more volatile than long-term rates.

We know from our technical analysis that the stock market and the dollar are both affected by interest rate changes, and that there is a positive link between stocks and the dollar, though sometimes with lengthy lead times. A declining dollar will eventually direct the prices of stocks lower due to the rise in interest rates and inflation. A rising dollar will ultimately push interest rates and inflation lower, which will be bullish for stocks.

When we analyse the relationship between stocks and the dollar we must take into account fluctuation in commodity prices (inflation) and changes in the bond market (interest rates). The dollar will affect the stock market only after moving through the other two sectors.

A pattern that forms at market turns aids reversals in stocks, bonds, and the dollar. When interest rates rise, the dollar will turn up first. After a time the advancing dollar will push interest rates lower, and the bond market will see a positive response. Stocks will then move upwards. There will be a period of declining interest rates while bond prices are rising and the US dollar will hit its peak. At this time the dollar will begin to fall and start to push interest rates higher. The bond market will peak and the stock market will follow. This entire process may encompass several years.

In summary, there is a direct relationship between interest rates and the US dollar; they follow each other in a circular fashion. Long-term interest rates affect the dollar less than short-term rates.

All four market sectors - stocks, currencies, interest rates, and commodities - are linked. Intermarket analysis helps us understand the following series of event:

1. The dollar is pushed higher by rising interest rates.
2. The precious metal gold hits its peak.
3. The CRB index hits its peak.
4. Bonds hit bottom and interest rates peak.
5. The stock market bottoms out.
6. The dollar is pushed lower by declining interest rates.
7. The precious metal gold hits bottom.
8. The CRB index hits bottom.
9. Bonds hit their peak and interest rates rise.
10. The stock market peaks.
11. The dollar is pushed higher by rising interest rates (back to step 1)

 

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[Excerpt from International Encyclopedia of Technical Analysis by Joel G. Siegel, Jae K. Shim, Anique Qureshi and Jeffrey Brauchler. Published by Vision Books.]

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