The сross-market analysis and correlation between financial markets
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  1. #1
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    The сross-market analysis and correlation between financial markets

    The сross-market analysis it’s the topic in it’s own right. It’s important for all traders, doesn’t matter if you trade on Forex or on the other markets. The understanding of interconnections between financial markets gives to trader conception about market movements and the reasons, why they happen. Everyone should know this, even if trader deals only with usage of technical analysis or other types of it.
    The сross-market analysis studies correlation between financial markets (four major asset classes: stocks, bonds, commodities, and currencies). The main goal of intermarket analysis is price movement forecasting. This analysis works not just for long- and medium-run strategies, but also for intraday trading.
    However, the topic of сross-market analysis isn’t in largely disclose in modern financial literature. Only one book, written 30 years ago, gives us knowledge
    and experience in this direction - “Intermarket Analysis: Profiting from Global Market Relationships” by John J. Murphy. A big half of information is outdated, but anyway let me recommend you to read it like a classics of the genre.
    Murphy reckoned intermarket analysis to the technical analysis feasibly cause he was classical in this direction. In my opinion, intermarket analysis(IA) is a part of fundamental analysis, because IA explores exactly reasons of price movements (nevertheless, charts are also used for this).
    In this thread we will try to discuss IA in simply way in order to help each beginning trader to straighten out.


    Introduction
    It happened in 2010. In one website I have found a posting from beginner in trading. He was very surprised when one day he opened index chart on small timeframe intraday and discovered that a good half of currency pairs just copy this index movement (for example, AUDUSD and other). Then he realized why currency movements are so sharp and are changeable from one side to another. That was a big revelation for him. I gave him advice to continue learning stock indexes, if he want’ to become a professional trader.
    Beginning trader doesn’t understand why currency pair price is so dynamic within a day or during a week. Primarily they get to know about news at the market and
    macroeconomic indicators outputs. They follow this news and think, that it’s a real fundamental analysis.
    After that beginners extend their knowledge and got to know about monetary factors which also affect the market. For example rate growth expectations lead to currency's value growth.

    So, the main factors, affecting currency value, are:

    1.Differrence in Interest Rates between the currencies of two countries. Investment in assest of country, whose interest rate is higher, gives more income and that means that the currency value of this country is more expensive and demanded.
    2. Interest Rate growth expectations lead to growth of the exchange rate (and vice versa, rate's fall makes currency value cheaper).
    3. Quantitative easing implementation (QE) makes value of currency to go consistently lower during the whole period. Expectations of QE fulfilment makes currency of this country more attractive and expensive.
    4. Other monetary and fundamental factors. For example, debt crisis in 2011-2012 led to sharp euro weakening .


    However, during the day currency price is defined by other factors:
    1. News distributing and and macroeconomic indicators performances.
    2. Intermarket relationships. The impact of other markets on the movement of exchange rates.

    The main classifications financing assets market types:

    The four main assets classes are:
    1. Currency
    2. Commodity assets
    3. Stocks
    4. Bonds


    According to classification above, the four main market types are:
    1. Foreign exchange market
    2. Commodity market
    3. Stock market
    4. Bond markets
    Let us look more closely on each financing asset and market later in the thread.



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    Risky Assets vs Safe Assets

    I. Risky assets. This asset type is bought when market is on positive trend and there is no negative factors like geopolitical tensions, wars, default etc.

    1. Stocks are the most risky assets. Revenue is obtained basing on stock price increases and on earnings from dividends.
    2. Almost all commodity assets also belong to this group.
    3. High-yield commodity currency (like as AUD, NZD, RUB, MNX etc.) also are included to the list of risky assets. The higher base interest rate of the country is - the higher profitability of
    this curerency becomes. In theory this currency should be more expensive, but it's all down to the safety of investment in assets of this country.

    II. Safe Assets. Investors prefer this assets during the geopolitical tensions, wars, disasters, etc.

    1) Japanese Yen. This funding currency is using for carry-trade (description is below).
    2) Government bonds of USA, Germany and other countries with highest
    credit rating. Their revenue is minimal, but investors buy them because of their safety.
    3) Gold is traditional safe-haven assets for investor.
    4) Swiss Franc. During last years SHF has largely lost its attractiveness as safe assets due the high overbought.
    5) US Dollar. Almost entirely had lost all investor’s trust as safe-haven asset after four times increasing of base interest rate up 1.25%. Today USD is traded closely to high-risk asset category.

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    In the continuation I would like to explain some basic concepts. I guess most of you know them. But in my experience, forex beginning traders don’t have enough knowledge about these concepts.


    Futures Contract


    The most spread type of financial assets, which are traded on market, are futures contracts. The exceptions are currency pairs, precious metals (gold, silver), and stocks, which are traded on forward market.
    The spot market or cash market is a public financial market in which financial instruments or commodities are traded for immediate delivery. In a spot market, settlement normally happens in T+2 working days, i.e., delivery of cash and commodity must be done after two working days of the trade date.

    Futures are financial contracts, which oblige the buyer to purchase an asset or the seller to sell an asset, such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.

    The situation, when a future contract price is little bit higher than an asset's price is called 'Backwardation'. Contango is the opposite of backwardation (an asset price is higher than a future’s price).
    The futures charts and asset charts seem to be the same in about 99% usually. That’s why, there are no distinctive difference in asset and the futures for it in the context of chart’s analysis. When we’re talking about asset, we would mean future contract on this asset.

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    Stock market


    Primary and secondary markets
    We are interested in secondary market. An initial public offering (IPO) is the simultaneous asset (or action), which is happening at the moment of firts asset’s issue into the market. After this, the company's shares are traded in an open market. Those shares can be further sold by investors through secondary market trading. The company receives funds for published shares, after that increase or decrease of share’s price doesn’t affect the company's activity. Shareholders can’t lose or earn millions of US dollars because of price fluctuations, like different newspapers confirm about it. Actually, it’s a “theoretical” money. For example, share’s value is increasing, but if we decide to sell our shares, than their price can significantly drop.


    Stock index is a basic instrument on stock market, which represent the cost of defined “basket” of shares, which in turn was calculated in a certain way.

    American, European and Tokyo stock exchange market are most important ones.


    American Stock Exchanges. There are two stocks indexes - Dow Jones 30 (DJIA), 30 “blue chips” index, and S&P 500, which shows the value of stocks of the 500 largest corporations, listed by grade of their market capitalization. The trading volumes are nearly the same and this fact indicates that both these index futures are broadly popular trading instruments, but their step volume sometimes is different. DJIA volatility is higher and shows smaller price movement owing to smaller tick size (minimum price fluctuation) .

    There is also the third biggest and popular US stock index - the index of high-tech companies (or hi-tech) - Nasdaq, but it usually moves quite differently from the first two indices - DJIA and S&P 500.


    DJIA index has ticker symbol YM and S&P 500 - ES. Future contract markets are liquid around the clock, while stock indexes trading time is 9:30 AM TO 4:00 PM ET. The futures intraday range offers more value for analysis in comparison to the stock indexes. Most trading platforms offers futures for trade and not the index itself.
    Nota bene: futures are classified as commodities. However, for analysis of intermarket correlation it’s no so important, since the futures move in a similar way to their asset.


    European Stock Market. The main indicative stock index, in my opinion, is the stock index of Germany, the most important EU country, - DAX (the index of 30 "blue chips" It’s equivalent of the DJIA on Frankfurt Stock Exchange). The main index of France - САС40.


    Tokyo stock market. The main indicative stock index is Nikkei (or Nikkei 225), which expresses the value of 225 shares of Japan's largest companies.

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    Commodity market


    Commodity assets are classified into several basic groups:
    1. Metals
    a) precious metal: gold, silver, platinum;
    b) industrial metal: copper, nickel, aluminum, campanil, etc.
    2. Energy sources: oil, gasoline, distillates, etc.
    3. Grain: wheat, corn, soy, etc.
    4. Soft commodities: cocoa, Cotton, coffee, etc.


    The main commodities affecting theforex market are gold, oil and copper.


    Gold is trading on spot and on futures markets.
    We can trade Gold in the spot markets, and we could also trade it as future contract.
    Theoretically, this commodity has obverse dynamics with US dollar: when US dollar is strong, the gold price generally goes down and and vice versa.

    However, possible shades should be taken into consideration. Since 2011, gold has been in a downward trend, and in the past few years has moved to a lateral trend in the range. Therefore, we should pay attention to last gold movement in the range in order to identify cross-market correlation. When trend of gold changes, the last tendention also would be changed.


    Oil has the same obverse dynamics with US dollar as gold. Until 2014, oil had strong correlation with stock indexes. But since 2014, oil trend was downward, and in last 1-2 years, the trend has moved sideways in the range. Almost all correlations were violated.
    Theoretically, oil has a very strong direct correlation with such "petroleum" currencies as the Canadian dollar, the Mexican peso and the Russian ruble - however, and this correlation was violated quite recently.


    Copper is traded usually in a "bunch" with the rest of the industrial metals, and has a noticeable direct correlation with such a commodity currency as the Australian dollar.


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    Bond market

    The world's leading bond market is the USA market. This is generally the largest market for financial assets in the world, so it has strong impact on all markets, although this impact can be not rather seen at first sight.
    The tradable and negotiable debt obligations issued by a country's government are called treasures. The main indicative instrument is Benchmark.

    The two major criteria for treasures are cost and revenue. It’s important to understand, that these two indicators (cost and revenue) are in inverse proportion: if the price of bonds is growing - then their profitability is reduced. The profitability calculation formula is not provided, but it’s sense is in the following: the price is the denominator, therefore, when it grows, by dividing we receive the lower the result.

    Treasures are traded on the primary and secondary markets. Primary market is a planned primary placement of newly issued bonds, which is usually held once per month. Then, these bonds are traded on the secondary market - and the result of this we can see in the platforms in the form of futures on this asset (in terminals MT is rare).


    Since European debt crisis (2011-2012), the information about primary bonds placement started to appear in economic calendars. Then they were carefully monitored, but today it’s practically meaningless. The main market for the movement of this asset is the secondary market.
    The correlation between US treasures and other assets is quite complicated recently. But direct correlation between treasures yield and US dollar can be seen clearly. This perspective is applied, in particular, to the pair USD/JPY. For bond’s and dollars’ prices the correlation will be invert.


    Below is the chart for Benchmark (black line).
    USD/JPY - red- blue line
    TY- 10-Year T-Note Futures




    Euro currency has also strong and invert correlation between the treasuries yield and the exchange rate . At the same time, the correlation of the pair EUR/USD (red-blue line) with the prices for bonds (the black line) is direct, as it can be seen on the chart below:


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    Let us discuss about funding currency and carry-trade .

    Funding currency - is the currency being exchanged in a currency carry trade. A funding currency typically has a low interest rate. Investors borrow the funding currency and buy assets with higher interest rates.
    The major funding currencies are : Japanese Yen (JPY) with base interest rate (-0,10%), Swiss Franc (CHF) with a base interest rate (-0.75%) -
    these currencies are also protective assets. In the past, the US dollar was also referred to the funding currency, when the base interest rate was 0.25%.


    Since the beginning of 2015, when the European QE (quantitative easing) was introduced, the Euro could be attributed to the funding currency, but at the moment the Euro is about to lose this status.
    Funding currencies are used in "carry-trade" transactions.


    "Carry-trade" transaction - is the process of borrowing low-yielding currencies and selling them with a purpose to purchase high-yielding currencies. For example, Japanese funds actively buy shares of American and European corporations and treasures of these countries.

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    The Japanese Yen is the main currency in the relationship between stock markets and forex

    The JPY is the mediator in сross-market correlation. How it’s work: in order to buy American and European assets via curry-trade transactions, Japanese funds sell the yen and buy US dollars, Euro. After that they buy US or EU stocks.
    What happens in this case with the dollar and US stock indixes? They're growing. USD/JPY and US stocks are growing. At the same time Japanese Yen value is dropping.
    In the case of stock market crush, JPY value will increase and the instrument USD/JPY would fall. This is process of market correlations.


    Let us check something on chart with m5 or m15 timeframes. We can open chart with any American or European stock index, we will face thr fact, that they are moving in the same way as USD/JPY.
    And almost always, the initiator of the movement are stock indices, like more volatile instruments.


    The direct correlation between USD/JPY (black line) and futures on the DJIA index (blue-red line), m15, September 11-19, 2017.




    It seems as the USD/JPY copies the movement of the stock index and not vice versa.. And may be it is the true, since the stock index consists of many individual stocks, and it is more difficult to influence it, than to affect a separate currency or share. A stock trader trades basing usually on their preferences, rather than looking at the currency market.
    For sure, this correlation is strong only when there are no other leverage over
    movement on Foreign market exist, primarily from a monetary category. And if they do exist, for example like since 2012, when the Bank of Japan launched the program of Japanese QE - these сross-market correlations worked somehow
    differently, more weakened. Then USD/JPY grew quite strongly, and the stock assets (with the exception of Nikkei) could not keep up with the pair.

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    Japanese Yen and the Japanese stock index Nikkei 225


    Especially significant direct correlation yen has with the Japanese stock index Nikkei 225, which is clearly seen in the chart below.



    USD/JPY (black line) and futures on the index Nikkei 225 (blue-red line), h1, August-September, 2017.


    That's why it's so important for everyone, who trades in the USD/JPY pair, to track the Nikkei 225. One of the ways to trade this instrument is like that:
    We should take attention to decorrelations which frequently appear intraday or during the week, between JPY and Nikkei . After We make conclusions about potentially USDJPY-moving.
    For example. Nikkei grew significantly and updated the maximum for the week (month, quarter, etc.) - and the USD/JPY didn’t show the same or comparable growth - that means that the growth of the currency pair was lagging behind the movement of the stock index.


    In this case, it’s possible that USD/JPYwill show outrunning growth in comparison with the index - it would catch up the index.
    The currency often lags behind the stock index, as stock assets are usually more volatile and more sharply fluctuate.
    Certainly, over the past six months the dollar is too weak and this method may not work - however, previously this method worked in 80% cases. And if the market returns to its more normal state, this technique will also become more efficient.


    All this points to the fact, that during considering all correlations, it is necessary to keep in mind more general monetary factors that affect the currency and may violate for some time all the previously established stable correlations.


    By the way, the Nikkei index (isn’t futures) shows dynamics of only 6 hours a day - this is the time of the Japanese stock market ( 03.00 am- 09.00am, UTC+3)
    From these 6 trading hours, an hour and a half is a break, it lasts from 5:00 to 6:30, UTC+3.

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    Japanese yen and other major currencies


    What happens on Forex market, when in the economic calendar there is no output of any significant macroeconomic indicators? And there are no other fundamental events that can cause movement intraday. How to navigate in trade in this case?
    Vary often on such days the Japanese yen heads movements for all other major currencies. Stocks market is indirectly affected by Forex market via JPY.
    The pair USD/JPY is growing, and US dollar starts to grow in relation to most other currencies. And vica versa the yen is growing, and this will weaken the dollar in other currency pairs. Especially if this movement coincides with the current day trend.


    The JPY movement correlation vs euro is currently even more than 50%, based on my observations. But other currencies, such as the gbp aud nzd, also react.


    The chart below shows the inverse correlation between USD/JPY (black line) and EUR/USD (blue-red line), weekly chart, 2009-2017:



    The next chart shows the inverse correlation between USD/JPY (black line) and EUR/USD (blue-red line), h1, 25th August - 22nd September, 2017.





    As we can see, the direct correlation between these pairs was observed only 5 days (from 14th- till 19th September) from the 4-week period, which partially was caused by specific conditions of waiting the results of the Federal Reserve System Meeting on 20th September, 2017.

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