The broad market is a vast and perplexing environment. For the enthusiastic investor, especially one who tracks several indices and asset classes, it might be too much to handle. For this reason, it is helpful to study the correlations between the four main markets: currencies, equities, bonds, and commodities. Intermarket interactions have the potential to improve portfolio diversification, make trades more intelligently, and shed light on the larger picture of investing. Investors may be better equipped to determine the possibility of changes in a market’s trajectory by keeping an eye on all of them. First, let’s examine the relationships between commodities, bonds, equities, and currencies. The cost of products increases in tandem with rising commodity prices. Interest rates rise in response to the expanding inflation, which is caused by this increasing price action. Bond prices decrease when interest rates rise because interest rates and bond prices have an inverse relationship. The relationship between bond and stock prices has evolved over time, with a stronger positive correlation (i.e., a move in the same direction) in the 20th century. Nonetheless, the connection was negative starting in 1998 and continuing until 2019. Stocks underperformed when bonds did well, and stocks fared well when bonds did badly. Investors benefited from this as it allowed them to limit losses and lower portfolio risk since the assets acted as a hedge for one another.
The connection then changed back to positive when the inflation rate began to rise in 2020. As interest rates and inflation have increased, the value of stocks and bonds has decreased. Will this favourable association be true going forward? The conventional explanation for a positive association is that bonds are often viewed as less hazardous investments than equities. Consequently, investor demand for bonds may rise while that for stocks may decline when bond interest rates rise. So what are the steps to do fundamental analysis? Typically, fundamental research is conducted from a macro-to-micro viewpoint in order to pinpoint stocks that the market has not appropriately valued.
Prices of stocks are negatively impacted by declining demand. Furthermore, as interest rates rise, businesses find it more expensive to borrow money, which drives up expenses and downsizes profits, further pressuring stock values (particularly when expenses exceed income).
In light of rising borrowing costs and inflation-related corporate expenses, it makes sense to believe that equities will perform worse for corporations. Bond price declines may not always coincide with a downturn in the stock market.
All markets are impacted by currency, but commodity prices are the most direct. Bonds and stock prices are also impacted by commodity prices, but the U.S. dollar and commodity prices often follow different trends. The dollar’s depreciation in relation to other currencies is reflected in commodity prices, which are denominated in US dollars. As previously stated, falling bond prices and increasing commodity prices together do not indicate a sell signal for stock market investors. But, if bonds continue to trend lower and their yields rise, the moves may indicate that a reversal is likely.
During this period, a bull market might still yield tremendous returns because there is no obvious warning to sell equities. When bond prices have already begun to decline, investors should be on the lookout for equities falling below a moving average (MA) or important support levels being taken out. This would be evidence that stocks are reversing and an intermarket connection is taking hold.
For example, equities and bonds decoupled in the American markets during the 1997 Asian financial crisis. This led to a negative connection that persisted until 2019. Why did this happen? Conventional market interactions presuppose an economy characterized by inflation. Therefore, certain connections may change when we enter a deflationary or low-rate environment.
Stock prices will often decline during deflation as low growth potential might result in a drop in value. Conversely, bond prices will probably rise in response to declining interest rates (keep in mind that bond prices and interest rates move in opposing ways). Consequently, in order to be prepared for a potential shift in the connection between bonds and equities, it’s critical to understand inflationary and deflationary circumstances.
There may be instances where a market appears to move very little, regardless of the state of the economy. That does not imply, however, that other regulations will not also apply. For instance, stagnant commodity prices and a declining US currency are likely adverse signals for bond and stock markets. Relationships may endure even in stagnant markets since the economy is always influenced by a number of different variables. The following graphic gives you an understanding of the several elements that might promote a positive or negative correlation between bonds and equities at different points in time. Considering global factors is also crucial. Companies have a significant influence on the future of the US markets as they grow more international. For example, when businesses grow, there may be an inverse link between the stock market and currencies.
This is because as businesses expand their global operations, the value of the money they bring back to the United States increases as the value of the dollar declines, resulting in higher profits. It is constantly necessary to comprehend the changing dynamics of global economies in order to perform intermarket analysis successfully. When investors are aware of intermarket linkages, they can offer worthwhile investment possibilities. Investors, however, need to be conscious of the long-term economic landscape and modify their Intermarket connection research appropriately. Investors should utilize a variety of methods to determine a market’s direction and if a trend is likely to persist over time, with Intermarket research being only one of them.
