Trading on divergences and convergences between related markets can produce profitable trades with very high success rates. Strategies that intermarket analysis of forex markets opening relationships between markets are a favored play of the institutional trader. Yet intermarket analysis as it’s called is a missed opportunity in my view.
Many traders ignore the subject almost entirely, preferring to focus on one market at a time. So those open to learning about this method can certainly gain an advantage. Financial markets don’t exist in isolation. Many have fairly predictable inter relationships with each other. Intermarket analysis is the study of these interactions. The table below shows some relationships.
Australia is a big producer of raw materials and tends to benefit from commodity upcycles. AUD tends to appreciate relative to other currencies in such cycles. New Zealand’s economy is closely coupled to that of its northern neighbor. Canada is a major oil exporter and its economy is tied to the commodity cycle. The FTSE-100 share index is heavily weighted in mining and commodity stocks and tends to suffer when commodities are weak. Japan is a net importer of raw materials and its industries are sensitive to these cost. Rising commodity prices tends to be negative for the yen.
Rising raw material costs often portend rising inflation, and as such higher global interest rates. Stock prices and bond prices tend to move together. P 500 and the 30Y US treasury bond. According to Murphy this relationship reverses in a deflationary environment. When commodities rise bond prices tend to fall because rising commodities are a leading indicator of inflation. When commodities fall bond prices tend to rise. The list above is not exhaustive by any means but gives an idea of the many relationships that exist.
In this post I want to look at the practical side this subject. What I will show is how just a basic knowledge of these interactions can produce a reliable trading system. Divergences are where two markets which usually follow a relationship split apart from one another. Take for example where two markets usually rise and fall together. A divergence takes place when one rises and the other falls. Where one market follows the other, there is often a delay where a move in the leader market is not fully-priced into the follower.