Relational Analysis Explained

book-threedimensionalapproachOne of the biggest mistakes virtually all forex traders make is to assume that currencies and currency markets move in isolation from all the other capital markets, somehow trading in a vacuum and entirely disconnected from the principle financial markets. Nothing could be further from the truth, as the foreign exchange markets lie at the heart of the money flow, creating a complex web of inter market relationships which dictate the ultimate flow of capital from one market to another.

Every decision taken by every investor, trader or speculator is about money, and ultimately it is money that flows through the foreign exchange markets, where governments, central banks, investors and speculators all meet to buy and sell currencies and to benefit from the consequent positions. Whilst it is undoubtedly true that some currency transactions are from real businesses who simply need to exchange currency to purchase goods and services or to pay suppliers, the largest percentage of transactions is from speculators and investors looking to take advantage of price movements in the short or longer term. Coupled with this is the never ending ebb and flow of risk, which translates into strength and weakness across the various asset classes.

If we consider for a moment the three related principle markets of bonds, equities, and commodities, then each has it’s own profile and tells us something different about the attitude to risk which defines the broad landscape for trading each and every day.

Bonds and the bond market

Of these, bonds are perhaps the least understood, and generally ignored by most forex traders, first because they mistakenly believe that they have no relationship to the currency markets, and secondly because they appear complex and dull. Once again this is far from the truth, as the bond markets give us clear unequivocal signals about risk appetite and the consequent flow of money, with the US bond market taking centre stage.

In simple terms, a bond is nothing more than an IOU. Bonds are the basic ingredient of the world’s debt capital markets, because this is where money is borrowed by, and lent to governments, companies, municipal organizations, and countries. Bonds are loans, short and simple and as such they not only tell us about the money flow between all the various market participants, but also the actual cost of money as a result. In addition, they also reveal a variety of deeper trends, including market sentiment and risk, as well as the longer term economic outlook which reflects interest rates, inflation and many other factors which then have a direct impact on the currency markets.

Now unlike a conventional mortgage or business loan, these loans are tradeable in the secondary markets and are often referred to as fixed income instruments or the fixed income market. Bonds are issued in order to raise money, and the borrower is then required to repay the amount borrowed, plus interest over a specified time, which is termed the maturity.

In general there are three types of bonds. Those with a maturity of less that one year, those with a maturity of between one and ten years and those with a maturity between ten and thirty years, and as forex traders there are really only two bond markets that are of interest to us. These are bonds denominated in US dollars and bonds denominated in so called eurodollars, which refers to US dollar deposits outside of the US.

The reason we concentrate on the US dollar is simply because this is the prime driver for money across world markets, and the US bond market is the biggest in the world by some distance. Within the US bond markets there are three bonds we watch carefully. Namely T bills, which are those with a maturity of less than one year, T Notes which are those with a maturity between one and ten years, and T bonds which are those with a maturity between ten and thirty years, and in studying bonds, we are solely interested in one aspect – the bond yield.

Imagine you are a property investor and are looking to buy a house to rent out to prospective tenants, and are looking to buy in two different areas. Both have an average rental potential of $500 per month, but the property on one area costs $50,000 and in the other costs $75,000. The rental yield on the first property would be 12% per annum whilst on the second would be 8%, and as a property investor we would choose to buy the cheaper property as this is giving us a better yield.

This in simple terms is how yield works in the bond markets. As the price of the bond increases then the yield falls, and as the price of the bond falls then the yield rises, and it is this constant change in yields in the bond markets that reveals so much about market sentiment and risk appetite. Why? Well, put simply, bonds are seen as a safe haven asset class, so that when money is flowing into the bond markets, this forces the underlying price of bonds higher, with yields falling as a result. Conversely, when the money flow is away from bonds and into other riskier assets, as risk appetite returns, then bond prices fall as bonds are sold, leading to a rise in the bond yield.

Put simply, when underlying bond prices are rising, in other words they are in demand, then their price rises and so the yield falls, and when underlying bond prices are falling, in other words they are no longer in demand, then their underlying price falls and so the yield rises. This is a key point which often surprises forex traders. Bond prices change all the time, and this change in the underlying price is reflected in the yield, or more particularly the yield curve which is the key component of the bond market on which professional traders focus their attention, as it is the shape of the yield curve which reveals the longer term prospects for interest rate changes in the underlying currency.

This is why the bond markets and the yield curve are so important to us as forex traders as they reveal both the market mood in terms of sentiment and risk, and therefore which currencies will perform better, and which are likely to perform worse, but also the longer term prospects for inflation and interest rates. It’s also important to remember, that whilst these figures are crucial to us as traders and speculators, they are equally important to the policy makers  in their monthly decisions on interest rates and monetary policy. The irony is that few forex traders take the time or effort to understand this related market,  yet it sends us both powerful and revealing signals every day, and when added to the other key markets of commodities and equities, the jigsaw of complex inter market relationships is complete.

Commodities and equities

Commodities and equities are of course an integral part of the relational jigsaw, and once again these markets provide us as forex traders with vital clues to sentiment and market mood, as well as to the longer term picture for the US dollar and ultimately inflation which is the key driver for interest rates, which are ultimately the blunt instrument which all central banks use to control the economy.

This is why economies invariably move from boom to bust in relentless cycles, since the tool used as a brake is generally running at least 9 to 12 months behind, as any changes in interest rates take time to filter their way into the economy, which is generally too late. It’s rather like slowing down an oil tanker, which takes around ten miles – the economy is like a juggernaut moving with huge momentum, so that even when the command has been given to slow the engines, the tanker still keeps moving at much the same speed. It’s the same with the economy and interest rates – the economy will continue to move at the same speed for some time, before the rate increase, or decrease begins to take effect.

Commodities are a key indicator of inflation, as they provide the bridge between the world of money and goods, and as commodity prices start to rise, so price increases are driven into the global economy. Whilst inflation is good for jobs and growth, too much and the economy runs out of control, too little and the economy remains stagnant, and may indeed fall into a recession or depression. It’s a double edged sword, and is the measure that all central banks fear and welcome in equal measure.

Commodities are all priced in US dollars, so as a general rule as the dollar weakens then commodity prices rise increasing inflationary pressures as a result and generally resulting in a longer term rises in interest rates.

Equity markets

Finally of course to compete the picture we have the equity markets, which give us clear signals as to the risk on or risk off appetite for investors, and in simple terms, if the equity markets are strong, then this signals a risk on appetite with investors prepared to move into riskier assets, and as such certain currencies will follow suit. In particular the euro over the last 2 years has shown a strong correlation to the the equity markets, as it is considered to be a risky currency. So when equities are rising, you will generally see the euro follow as it strengthens against other major currencies such as the US dollar.

This is why relational analysis is such an important part of the forex trading world. The pieces of the jigsaw are all there, we simply have to arrange them in the right place to complete the picture.