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Intermarket Analysis and Sector
Rotation
Module Overview
Chapters
In this Module, we shall talk about Intermarket
Analysis and Sector Rotation. Up until now, we have
primarily talked about asset classes individually. Now
is the time to combine the four primary asset classes
that are traded in the market. These include
currencies, commodities, bonds, and stocks.
Combining the four adds a new dimension to analysis
and enables one to get a more holistic picture of the
overall markets. It also helps a trader to understand
the business cycle better, which in turn can play an
important role when it comes to understanding and
deploying sector rotation strategies
School of Stocks by Fyers © 2018 – 2023. All rights reserved.
Reproduction of the materials, text and images are not permitted.
1. The Four Asset Classes
10 Lessons
In this introductory chapter, we shall introduce the four
asset classes that we will be talking about throughout
this module. These four asset classes include currencies,
commodities, bonds, and stocks. We shall conclude this
chapter by highlighting the importance of Intermarket
Analysis and explain why every trader/investor must pay
attention to the price action and the trends of each of
these asset classes.
2. Dollar and Commodities
18 Lessons
In this chapter, we shall study the correlation that exists
between the dollar and commodities. From an
intermarket perspective, it is important to understand
the correlation between the two and to then monitor the
trajectory of these two asset classes on a real time basis,
given the influence they can have on the trends of other
asset classes, namely bonds and stocks.
3. Commodities, Bonds, Inflation, and
Interest Rates
9 Lessons
In this chapter, we will study the correlation that exists
between commodities and bonds and the crucial role
that inflation and interest rates play in influencing this
correlation. Trends in the commodity and bond market
can and do influence the trajectory of the stock market.
As such, it is pivotal for one to understand the
correlation between commodities and bonds at various
points in time and then monitor this correlation
periodically on a real time basis.
4. Bonds and Stocks
7 Lessons
In this chapter, we will explain the correlation between
stocks and bonds and the role interest rates play in
impacting stock prices. It is important to understand how
the two correlate to each other and keep a track of how
that correlation is evolving over time. Often, change in
the direction of bonds can influence the direction of
stocks as well
5. Commodities and Stocks
9 Lessons
In this chapter, we shall study the fourth most critical
intermarket relationship, which is the one between
Commodities and Stocks. When comparing the
correlation between the two, we shall talk about
commodities, both from a collective perspective as well
as from an individual perspective.
6. Other Correlations
6 Lessons
In this chapter, we shall study the two remaining
intermarket correlations, which can add a lot of value
when tracked periodically while also provide clues on the
overall risk appetite of market participants. The
remaining two correlations that we will be covering in
this chapter include the correlation between:
* Currencies and Bonds
* Currencies and Stocks
7. Summarizing the Correlations
6 Lessons
n this brief chapter, we shall re-highlight the correlations
that we have studied over the course of the previous six
chapters. Note that there is nothing new in this chapter,
but just what we have said so far. In fact, this chapter can
act as a quick reference guide or as a primer whenever
someone wants to refer back to the correlations that we
have discussed so far in this module.
8. Using Ratio Charts to Identify Relative
Strength
7 Lessons
Having talked in detail about Intermarket Analysis over
the past few chapters, it is time to move on to the second
part of this module - Sector Rotation. In this chapter, we
will talk about a versatile tool that can be used to
identify relative strength between one instrument and
another.
9. Top-Down Approach: The Technical
Way
5 Lessons
In this Chapter, we will discuss how one could use the
Top Down Approach using Technical and Intermarket
Analysis. The objective of this approach is to scan from
the top to the bottom, so as to find out the strongest
markets/sectors and the strongest stocks within those
markets/sectors where capital could be deployed and a
portfolio of stocks could be created.
10. Top-Down Approach: Real World
Application
4 Lessons
Continuing from the previous chapter, in this chapter, we
shall talk about the practical application of the Top Down
approach on the Indian markets/sectors and stocks, and
how one could build a trading portfolio using this
approach.
 What do you want to learn?
by FYERS

Home : Intermarket Analysis and Sector Rotation

The Four Asset Classes

In this introductory chapter, we shall introduce the four asset classes that we will be talking about throughout this module. These four asset
classes include currencies, commodities, bonds, and stocks. We shall conclude this chapter by highlighting the importance of Intermarket
Analysis and explain why every trader/investor must pay attention to the price action and the trends of each of these asset classes.

Tejas Khoday (20th Jul, 20)

28 minutes read

In this Module, we shall talk about Intermarket Analysis and Sector

Rotation. Up until now, we have primarily talked about asset classes
individually. We have thoroughly covered currencies, commodities, and
stocks in our earlier modules. Now is the time to combine the four
primary asset classes that are traded in the market. These four asset
classes include currencies, commodities, bonds, and stocks. Combining
the four adds a new dimension to analysisand enables one to get a more
holistic picture of the overall markets.It also helps a trader to understand
the business cycle better, which in turn can play an important role when
it comes to understanding and deploying sector rotation strategies.

In this chapter, we shall introduce the four asset classes that we will be
talking about throughout this module. These four asset classes include
currencies, commodities, bonds, and stocks. We shall conclude this
chapter by highlighting the importance of Intermarket Analysis and
explain why every trader/investor must pay attention to the price action
and the trends of each of these asset classes.

Before we get started with this module and chapter, let me add an
important disclaimer. This module will talk in detail about different asset
classes and their influence on one another. Also, in this module, we will
rely quite a lot of charting. Because of all these, it is assumed that the
reader understands currencies, commodities, stocks, and technical
analysis. If not, we would highly recommend reading each of these
modules first from our School of Stocks portal, before coming back to this
module. With that, let us get started with the exciting world of
Intermarket Analysis and Sector Rotation.

Currencies

There are several currencies that are traded around the world. As per the
United Nations, there are 180 currencies at present. While most of the
nations have their own currency, a few do not and hence use foreign
currency for transacting. Then there are a few nations that use a common
currency among them. As a result, the total number of recognized
currencies are slightly less than the total number of countries around the
world.That said, 180 is still a big number. You might ask ‘do I need to keep a
track of these many currencies?’. The answer is no. Although there are 180
currencies, you need to track only a handful of them. The most important
currencies are the ones that are a part of the Majors group, the key Crosses
group, and the BRICS currencies.

If you remember from our discussion in the Currencies module, currencies

are always expressed in pairs and not in isolation. That is a currency of
one country is expressed against a currency of the other country. The
currency that appears in the numerator is called the base currency (aka
home currency), while the currency that appears in the denominator is
called the quoted currency. For instance, in the pair USD/INR, USD is the
base currency while INR is the quoted currency. This quote tells how
many units of the quoted currency are needed to buy one unit of the base
currency. For instance, if USD/INR = 75.00, it means 1 USD = 75 INR and
you need 75 rupees to buy 1 dollar.

The Major pairs The Cross pairs The BRICS pairs

EUR/USD EUR/GBP USD/INR
GBP/USD EUR/CHF USD/CNY
USD/JPY EUR/JPY USD/BRL
USD/CHF GBP/JPY USD/RUB
AUD/USD AUD/JPY USD/ZAR
USD/CAD

The above table shows 16 of the most important currency pairs. Within
these, if one needs to filter out a few pairs, the Crosses could be skipped.
The Majors and the BRICS pairs, however, are quite important to keep an
eye on periodically.

A common question that you might ask is ‘Is there an index that lets one
understand the trend of the currency market in general?’. The good news is there is
one: The Dollar Index, commonly abbreviated as the DXY Index.The DXY
Index is a trade-weighted basket that tracks the performance of the
Dollar against six major currencies namely the Euro (EUR), the Japanese
Yen (JPY), the British Pound (GBP), the Canadian Dollar (CAD), the
Swedish Krona (SEK), and the Swiss Franc (CHF). Below mentioned are
the weights of each of these currencies against the US Dollar in the DXY
Index.

As we can see from the pie diagram above, the Euro occupies nearly
three-fifths of the weight in the DXY Index. Hence, the DXY Index is
heavily influenced by the trajectory of the EUR/USD currency pair. The
chart below compares the DXY Index with EUR/USD.

Notice in the above chart how the DXY Index and the EUR/USD look like
mirror images of oneanother. See that they tend to move in the opposite
direction and that a top in one usually coincides with a bottom in the
other, and vice versa. Again, the reason why this happens is because the
Euro occupies a lion’s share in the DXY Index. Hence, movement in the
DXY is heavily influenced by movements in EUR/USD. A strengthening
DXY index usually implies EUR/USD is weakening, and vice versa.

The Dollar is the world’s reserve currency as well as the most traded
currency in the world. In fact, as per a report released by the Bank for
International Settlements (BIS) in 2019, the dollar is on one side of 88% of all
trades. Such is the global dominance of the dollar. Moreover, the dollar is
also used to price several international assets, such as commodities.
Because of all these factors, the dollar’s trajectory tells a lot about the
general trajectory of the global currency market. In other words, a
strengthening dollar means other currencies, in general, are weakening,
and vice versa. And as we said earlier, the best and the most tracked
proxy for measuring the dollar’s relative performanceversus other
currencies is the DXY Index. For our work on intermarket analysis throughout this
module, whenever we will refer to currencies, we shall primarily focus on the DXY
Index.

Commodities

Commodities are hard-assets because of their tangible nature. They are

also one of the most important asset classes because of their utility in our
day to day lives. Commodities can broadly be classified into four groups.
These are as mentioned below:

Precious metals

Industrial metals

Energy

Agriculture

Precious metals include gold, silver, platinum, and palladium. Industrial

metals can be sub-divided into two groups: ferrous and non-ferrous
metals. Ferrous metals include steel and iron whereas non-ferrous
metals include copper, aluminium, zinc, lead, nickel, brass, and tin. Energy
commodities include crude oil, natural gas, gasoline, and heating oil.
Finally, agricultural commodities include soybeans, wheat, rice, corn,
sugar, cotton, livestock etc.

Commodityprice movements can and do have repercussions across all

the other assetclasses. They are one of the key drivers of price pressure
(inflation/deflation) in any economy and as such, their price swings are
closely monitored by monetary authorities and by governments across
the world. At the same time, trends in commodities tell a lot about the
health and the well-being of the world economy as well. Because of these
factors, commodities are an extremely important asset-class to keep a
track of. Commodities play a major role in influencing the intermarket
trends.

There are three ways of tracking commodities. One is to track them

individually, such as tracking gold, copper, crude oil, etc. Doing so enables
one to understand what is happening in each individual commodity. The
other is to track sectoral commodity indices, such as precious metals
index, base metals index, etc. Doing so enables one to understand what is
happening in each commodity group. The third is to track all commodities
in entirety as one group, such as a commodity index. Doing so enables
one to understand what is happening among commodities, in general.

Individually, there are several commodities that are traded in the

markets. However, it is not necessary to monitor every single one of
them. One could, as an example, look at just one key commodity from one
particular commodity group. For instance, one could track gold from the
precious metals segment, crude oil from the energy segment, and so on.
Below mentioned are some of the most important commodities from
each segment that one needs to monitor frequently:

Precious metals segment: Gold

Industrial metals segment: Copper

Energy segment: Crude oil

Agricultural segment: Soybean, corn

Gold, copper, and crude oil in particular are three of the most traded and
the most eyed commodities of all. Their trends can say various things
about the global economy and the prevailing risk flows. For instance, a
rising trend of gold (a safe haven asset) and a falling trend of copper (an
industrial commodity) could suggest that market is in a risk-off mode and
that global economic conditions could be deteriorating, and so on. If a
trader or an investor cannot monitor the trends of multiple commodities,
then the trends of at least these three must be monitored frequently.

The chart above compares the trend of Brent crude oil and that of gold.
Notice the marked arrow. During this period, crude oil plunged as Covid-
19 outbreak and the subsequent global lockdowns drastically reduced
global demand for oil. On the other hand, gold prices shone during this
period as investors dumped risky assets and sought refuge in the safety
of gold. Over the last few weeks, notice that the two have moved in
tandem as lockdown relaxations coupled with production cuts from the
OPEC have helped ease the global oil supply glut, while monetary easing
by the Fed and other central banks have continued to boost gold prices.

The above chart is an equal weighted chart of precious metals, which

includes gold, silver, platinum, and palladium. This equal-weighted chart
shows the trend of precious metals as a group. The chart shows that
precious metals as a group traded strong for the first three months of
2020, plunged in April to wipe out all of the early year gains, before
recovering half of the losses since May. One could also assign weights to
each precious metal in the group, giving the highest weight to the most
important metal and the lowest to the least important metal.

The above chart is of Thomson Reuters (now Refinitiv) Core Commodity

CRB index. This index monitors the performance of commodities, in
general, and comprises of 19 commodities from different groups. These
commodities along with their current weights (as of July 2020) are
mentioned below:

Commodity Group Weights

WTI Crude oil Energy 23%
Natural Gas Energy 6%
Gold Precious Metals 6%
Copper Industrial Metals 6%
Aluminium Industrial Metals 6%
Corn Agriculture 6%
Soybeans Agriculture 6%
Live Cattle Agriculture 6%
Heating Oil Energy 5%
Unleaded Gas Energy 5%
Sugar Agriculture 5%
Cotton Agriculture 5%
Cocoa Agriculture 5%
Coffee Agriculture 5%
Silver Precious Metals 1%
Nickel Industrial Metals 1%
Wheat Agriculture 1%
Lean Hogs Agriculture 1%
Orange Juice Agriculture 1%

The table above shows the weights of individual commodities in the Core
CRB index. It can be seen that out of 19 commodities, WTI Crude oil
occupies a weight of nearly 25%. Because of a greater weightage given to
crude oil, the core CRB index is quite sensitive to fluctuations in the price
of oil. Also, it can be seen that out of 19 commodities, 4 belong to the
energy group, 2 to the precious metals group, 3 to the industrial metals
group, and 10 to the agricultural group.

The pie chart above shows the group-wise commodity weightings in the
CRB index. It can be seen that the agriculture and energy group have
nearly identical weightings and account for 80% of the total index
weight. The rest 20% belongs to the metals space. Kindly keep in mind
that the composition and weightings of the CRB index can and do change
over time.

The above chart is that of S&P Goldman Sachs Commodity index (GSCI).
This index monitors the performance of commodities, in general, and
comprises of 24 commodities from different groups. These commodities
along with their current weights (as of July 2020) are as mentioned
below:

Commodity Group Weights

WTI Crude oil Energy 25.31%

Brent Crude oil Energy 18.41%

RBOB Gasoline Energy 4.53%

Heating Oil Energy 4.27%

Gasoil Energy 5.95%

Natural Gas Energy 3.24%

LME Aluminium Industrial Metals 3.69%

LME Copper Industrial Metals 4.36%

LME Lead Industrial Metals 0.68%

LME Nickel Industrial Metals 0.80%

LME Zinc Industrial Metals 1.12%

Gold Precious Metals 4.08%

Silver Precious Metals 0.42%

Chicago Wheat Agriculture 2.85%

Kansas Wheat Agriculture 1.25%

Corn Agriculture 4.90%

Soybeans Agriculture 3.11%

Cotton Agriculture 1.26%

Sugar Agriculture 1.52%

Coffee Agriculture 0.65%

Cocoa Agriculture 0.34%

Live Cattle Agriculture 3.90%

Feeder Cattle Agriculture 1.30%

Lean hogs Agriculture 2.06%

The table above shows the weights of individual commodities in S&P

GSCI. It can be seen that out of 24 commodities, Crude oil (WTI + Brent)
occupies a weight of 44%. Because of such a significant weightage given
to crude oil, S&P GSCI is extremely sensitive to fluctuations in the price
of oil. Also, it can be seen that out of 24 commodities, 6 belong to the
energy group, 2 to the precious metals group, 5 to the industrial metals
group, and 11 to the agricultural group.

The pie chart above shows the group-wise commodity weightings in S&P
GSCI. It can be seen that the energy group accounts for over 60% of the
total index weight, while the agriculture group accountsfor just under
25%. Because of the greater weightings assigned to the energy group,
S&P GSCI tends to be extremely sensitive to trends in the energy market.
Meanwhile, the rest 15% belongs to the metals space. Kindly note that
the composition and the weightings of S&P GSCI can and do change over
time.

Besides the CRB index and S&P GSCI, there are various other commodity
indices including group-wise commodity indices, which we shall discuss
occasionally when talking about commodities from an intermarket
perspective. However, for most of our discussion on intermarket linkages,
whenever we speak of commodities, we will mostly talk from the viewpoint of the Core
CRB index and S&P GSCI, as these two arethe most-widely tracked commodity indices
in the world while also being considered as global benchmarks for tracking the trends of
commodities in general.

Bonds

Bonds are financial instruments that are issued by governments,

municipalities, and corporations (who are known as the borrowers or the
issuers) to raise capital in order to fund their financial needs. They are
issued for a certain period of time (ranging from a few months, in which
case they are usually called bills, to several years, in which case they are
usually called bonds) during which they pay periodic coupons to the
holders of these instruments (who are known as the lenders or the
bondholders). Bonds are usually issued at face value (aka par value). At
maturity, the face value of the bond is repaid in full to bondholders.
Meanwhile, the periodic coupons are interest paid by the borrower to
the lender for lending money for a certain period of time. Because bonds
pay periodic coupons, they are also known as fixed-income instruments. The
rate at which a bond is issued is called the coupon rate, which is also known
as the yield of the bond at the time of issuance. The coupon rate is
expressed as anannualized percentage of the face value of a bond.

When an issuer first issues a bond, the issuance is done in the primary
market. The place where already issued bonds are available for trading is
the secondary market. Several government, municipal, and corporate
bonds are publicly traded in the secondary markets. If a bond is publicly
traded, an investor need not necessarily buy the bond from the issuer.
Instead, he or she could buy it from the secondary market where it is
traded. Also, an investor could sell the bond in the secondary market
anytime up to its maturity, just like he or she could buy it in the secondary
market any time after its issuance. Buying and selling in publicly-traded
bonds is as similar to buying and selling in publicly-traded stocks.
Meanwhile, while the face value of bonds remains fixed, their market
value keeps changing depending upon several factors.The most
important factors that influence the market price of a bond are the
coupon rate versus the interest rate in the economy, credit worthiness of
the issuer, and time to maturity of the bond.At any point in time, the
market value of a bond could be below, equal to, or above its face value.

The objective of discussing bonds in this module is not to cover the

fundamentals of bond markets in detail. That is far outside the purview of
this module. Instead, the objective of discussing bonds is to understand
their role in the intermarket landscape. In order to understand this, we
must first understand the crucial role that interest rates play in
influencing bond prices and then understand the correlation between
bond price and its yield. So, let us get started. Keep in mind that for the
rest of our discussion on bonds, we will be talking about publicly-traded
bonds only.

Impact of interest rates on bond prices

One of the major factors that impact publicly-traded bond prices are
interest rates in the economy. As interest rates change, so does the
market price of bonds. Let us take a simple example. Let us say that a
bond has a coupon rate of 5% and the prevailing interest rate in the
economy is also 5%. Going forward, if interest ratesin the economy rise
above 5%, new bonds that would be issued in future would be issued at
higher coupon rates. As a result, demand for the existingbond that was
issued at a coupon rate of 5% will decline due to the lower rate it offers
over the market rate. Because of this, to maintain the attractiveness of
the existing bond, the market price of that bond will decline by an amount
that would compensate for the given rise in interest rate. On the other
hand, if interest rates in the economy drop below 5%, new bonds that
would be issued in future would usually be issued at lower coupon rates.
As a result, demand for the existing bond that was issued at a coupon rate
of 5% will increase due to the higher rate it offers over the market rate.
Because of this, the market price of that bond will increaseby an amount
that would compensate for the given drop in interest rate. It is for this
reason that the market price of a bond moves inversely with interest rates. That is,
bond prices fall when interest rates rise, and vice versa.

Inverse correlation between bond price and bond yield

Now that we understand the correlation between bond price and

interest rates, it is time to talk about the correlation between bond price
and bond yield. But what exactly is bond yield? Put it in simple words,
bond yield is the annualreturn an investor would earn on the bond. The
yield on a bond can be calculated as follows:

Note that in the above expression, annual coupon is expressed in value

terms. Depending upon the demand and supply for a bond in the market,
the market price of a bond keeps changing. On the other hand, the annual
coupon (in value terms) usually remains fixed over the life of the bond. As
a result, the bond yield keeps changing as the market price of the bond
changes. As the market price of a bond keeps changing, at any point in
time, the bond could be trading below, at, or above its face value. If the
market price of a bond is below its face value, the bond is trading at a
discount, in which case its current yield will be above the coupon
rate.Similarly, if the market price of a bond is equalto its face value, the
bond is trading at par, in which case its current yield will be equal to the
coupon rate. Finally, ifthe market price of a bond is above its face value,
the bond is trading at a premium, in which case its current yield will be
below the coupon rate. Let us understand this using a simple example.

Let us say that a bond has a face value of ₹100, a coupon rate of 6%, a
maturity period of 10 years, and a coupon that is payable semi-annually.
This means the annual coupon of ₹6 would be paid in two parts each year,
each part being ₹3.

What would be the current yield if the market price of the bond rises to
₹105? Let us calculate this using the above mentioned equation:
On the other hand, what would be the current yield if the market price of
the bond falls to ₹90?

Notice above that as the market price of a bond rose above the face value
of ₹100, the current yield fell below the coupon rate of 6%, and vice
versa.From this, we can see that there is an inverse correlation between bond
price and bond yield. That is, as bond price rises, bond yield falls, and vice versa.

From this, we can see that there is an inverse correlation between bond price and
bond yield. That is, as bond price rises, bond yield falls, and vice versa.

Combining bond price, bond yield, and interest rate

From the above discussion on bonds, as far as intermarket analysis is

concerned, there are three important properties that must be
memorized and kept in mind. These are:

Interest rates and bond prices are inversely correlated

Bond prices and bond yields are inversely correlated

Interest rates and bond yields are directly correlated

Hence, in an environment where interest rates in the economy are rising

or as expected to rise, bond yields trend higher while bond prices trend
lower. Similarly, in an environment where interest rates in the economy
are falling or are expected to fall, bond yields trend lower while bond
prices trend higher. This is applicable for both government bonds as well
as corporate bonds.

Categories of bonds based on their maturity period

Generally speaking, bonds could be split into three categories depending

on their maturity period. These are as mentioned below:

Bills – these have maturity of less than a year and are issued to raise short-
term capital. Examples include 3-month (or 91-day) bills and 6-month (or
182-day) bills

Notes – these have maturity of more than 1 year but less than 10 years and
are issued to raise capital for the medium-to-long-term. Examples include 2-
year note and 10-year note

Bonds – these have maturity of more than 10 years and are issued to raise
capital for the long-term. Examples include the 30-year bond

The above mentioned are the standard norms in the US. Some countries
don’t distinguish between notes and bonds. Instead, they call any fixed-
income instruments having maturity of more than 1 year as bonds.

Generally speaking, the longer the maturity periodof a fixed-income

security, the higher would itsyield be, and vice versa.For instance, the
yield of a 10-year Treasury note would usually be higher than that of a 2-
year Treasury note of the same country. Also, the shorter the maturity
period of a fixed-income security, the more sensitive will its yield be to
changes in interest rates in the economy, and vice versa. For instance, the
yield of a 2-year Treasury note will be more sensitive to changes in
interest rates than that of a 10-year Treasury note.

Inflation-linked bonds

The bonds that we have discussed so far are bonds that offer nominal
interest rates. That is, these bonds do not take into consideration the
prevailing level of inflation in the economy. Inflation, as you know,
dampens the real rate of return that is earned on any investment. For
instance, let us say that I invest ₹100 today in a 1-year debt instrument
having a yield of 5%. At the end of 1 year, I would get back my principle of
₹100 along with an interest of ₹5, which would be my return on
investment. However, what if the prevailing inflation rate in the economy
is 3%. In that case, the value of ₹100 today would be equivalent to ₹103 a
year down the line. That is, the purchasing power of money has reduced
over a 1 year period due to the effects of inflation. So effectively,
although I am getting a nominal return of 5% on the debt instrument, the
real return would just be around 2%, after taking into consideration the
inflation rate of 3%. Sometimes, it can also happen that the inflation rate
rises above the nominal rate, in which case the real rate of return would
turn negative. This is a really bad situation to be in!

Inflation-linked bonds help to address such inflation-related risks. They

are usually linked to a key measure of inflation in an economy, such as the
Consumer Price Index (CPI).From our prior discussion on bonds, we know
that the face value of a bond and its coupon rate remain unchanged
throughout the bond’s tenure and that the coupons are paid as a certain
percent of the face value of the bond. Even in case of an Inflation-linked
bond, the coupon rate remains unchanged throughout the bond’s tenure
and the coupons are paid as a certain percent of the face value of the
bond. However, there are two factors that separate a nominal bond from
an Inflation-linked bond. These are:

In an Inflation-linked bond, the face value of the bond is adjusted for

inflation. That is, as inflation in an economy rises, the face value of an
inflation-linked bond also rises.

Also, in an Inflation-linked bond, coupon is paid on the adjusted face value of

the bond. So, if the face value of the bond rises, so does the coupon that is
paid to the bondholder.

So, as we can see, in an environment where inflation is rising, the face

value of an Inflation-linked bond will be adjusted higher, because of
which investors would receive higher coupons. However, there is a catch
to this. What if an economy experiences deflation (i.e. negative inflation)?
In that case, the face value of an Inflation-linked bond will be adjusted
lower, because of which investors would receive lower coupons.If the
adjusted face value is below the original face value of the bond at
maturity, will investors get lower principle proceeds at maturity? Well,
the answer is no. In most cases, at maturity, the holders of an Inflation-
adjusted bond would receive an amount equivalent to the adjusted face
value or the original face value, whichever is higher. So, the lowest
possible principle proceed that the investor would receive at maturity is
the original face value of the bond. Let us understand this using a few
examples:

Let us say that an Inflation-linked bond has a face value of ₹100, a coupon
rate of 4%, and a maturity period of 10 years. Because this is an Inflation-
linked bond, the coupons will vary each period, depending on the
inflation rate.

What coupon would an investor receive if inflation rises by 3% over a year?

In this case, the face value would be adjusted higher to ₹103 (₹100 * 1.03).
The coupon that the investor would receive would be on the adjusted face
value of ₹103. This would amount to ₹4.12 (₹103 * 4%).

What coupon would an investor receive if there is no inflation over a year? In

this case, the face value would stay at ₹100. The coupon that the investor
would receive would be on theface value of ₹100. This would amount to ₹4
(₹100 * 4%).

What coupon would an investor receive if there is a 5% deflation over the

year? In this case, the face value would be adjusted lower to ₹95 (₹100 *
0.95). The coupon that the investor would receive would be on the adjusted
face value of ₹95. This would amount to ₹3.8 (₹95 * 4%).

Notice above that the coupon rate remains the same. What changes is
the adjusted face value depending on the inflation rate, which causes the
coupons to vary.

An advantage of Inflation-protected bonds over nominal bonds is that

they protect an investor from the adverse impact of rising prices.
However, a disadvantage is that they offer a lower coupon rate as
compared to that offered by similar-dated nominal bonds. Also, if there
not much inflation or, in a worse-case scenario,there is deflation, the
investor would end up receiving lower coupons because of lower
adjustment done to the face value of such instruments.

Inflation-adjusted bonds are available in a range of maturities, such as 5-

year, 10-year etc. In the US, Inflation-adjusted bonds are known as
Treasury Inflation Protected Securities, akaTIPS. US TIPS are available in four
different maturities, namely 5-year, 10-year, 20-year, and 30-year.
Among these, the 10-year TIPS is often considered a benchmark and a
proxy of real rate of return. Coupons on US TIPS are paid on a semi-
annual basis. Just like nominal bonds, US TIPS are also traded in
secondary markets, where buyers and sellers can transact in these
instruments any time they wish.

Turning focus back to intermarket analysis

Up until now, we have talked about some key bond-related nomenclature

that one needs to know before incorporating bonds into their
intermarket analysis. These included understanding the linkages among
bond prices, bond yields, and interest rates; understanding the various
maturities for which bonds are issued; and understanding the basics of
Inflation-adjusted bonds. Now that we are good to go forward, let us
proceed and see some charts of bonds.

The chart above is the daily chart of the 2-year US Treasury note yield.
Observe that the yield has been heading lower for well over a year, which
highlights that interest rates, in general, in the US have also been
trending lower over the last few months.

The chart above is the daily chart of the 10-year US Treasury note yield.
Observe that just like the 2-year yield, the 10-year yield has also been
heading lower for well over a year. In fact, the general trajectory of
sovereign bond yields of a nation across maturities tends to be the same.

Going forward, for most of our discussion on intermarket analysis, whenever we shall
talk about bonds in this module, we will primarily focuson sovereign bonds, that is
bonds that are issued by nations. We shall mostlytalk about US treasury bills (3-month),
notes (2-year and 10-year), and bonds(30-year) as well as about US TIPS (10-year). The
reason for talking primarily about US bonds is because the US bond
market is the largest, most liquid, and most tracked bond market in the
world. Also, actions in the US bond markets have strong repercussions
not only on US asset classes but also on other asset classes across the
world.

Equities

The fourth asset class that forms a part of our intermarket framework is
equities (or stocks). We won’t be talking about individual stocks in this
module. Rather, we shall talk about some of the key stock indices of the
world. The nations whose stock indices we would cover in this module include the US,
Germany, Japan, China, India, UK, and Hong Kong. We will also talk about combined
equity indices of developed markets and emerging markets. Later on, in this module, we
will drill down to sectors within the stock market, where we will lay emphasis on the US
and the Indian stock market sectors.

There are hundreds of stock indices in the world. However, it is not

possible to track each one of them. Instead, the focus should be the stock
indices that are quite important and are widely tracked by market
participants around the world. Some of the key indices that we would be
talking about in this module are mentioned below, along with the nations
to which these indices belong:

Index Nation
DJIA 30, S&P 500, NASDAQ, Russells 2000 US
DAX 30 Germany
Nikkei 225 Japan
Shanghai Composite China
Nifty 50, Midcap 100, Smallcap 100 India
FTSE 100 UK
Hang Seng Hong Kong
Equal-weighted chart of each nation BRICS
MSCI Index Emerging Markets
MSCI Index Developed Markets
MSCI Index World Markets

These are some of the most important indices that one must monitor
frequently. As you might be aware, as most markets today are
internationally linked, global equity indices tend to move in sync. That is,
most tend to rise and fall together, although the relative performance of
the index of one nations varies as compared to that of another nation.
Take the example of the 2000 dot com crisis or the 2008 global financial
crisis. During each of these crises, most of the world markets fell
together and subsequently recovered together. Even in the ongoing
2020 Covid-19 crisis, several world markets fell together in February and
March 2020, before bottoming out and rebounding together since then.
In today’s technology-driven era, the world markets are more closely
linked than ever. Hence, it makes sense to keep a track of not just one
market that interests you, but all the major markets around the world.

The above is the daily chart of the Dow Jones Industrial Average index
(DJIA), which is a price-weighted index that tracks the performance of 30
largecap US stocks. The DJIA is one of the most widely-tracked stock
market index in the world and is also one of the oldest stock-market
index. Notice in the above chart that after bottoming out near the start of
2019, the index was in a strong uptrend for virtually all year long.
However, after peaking out in early-2020, the index registered one of its
fastest falls in history, weighted by the Covid-19 crisis and its subsequent
impact on the US economy.

The above is the daily chart of the Nifty 50 index, which is a market-
capitalization weighted index that tracks the performance of 50largest
Indian stocks. Nifty is often considered the benchmark index of India and
is widely tracked by market participants. Notice in the above chart the
performance of Nifty. While the relative performance differs, observe
that movements in Nifty were quite similar to that of the DJIA shown in
the previous chart. This is in line with what we said earlier in this chapter:
most of the world equity markets and inter-connected and tend to move in sync with
each other.

Importance of understanding intermarket linkages

Broadly speaking, the four asset classes that we shall talk about in this
module are currencies, commodities, bonds, and equities. We shall study
the relationship between these asset classes and show that the price
trend of one asset class has a bearing on that of another asset class. In
other words, we shall show that there are correlations between these
asset classes and that these must be studied closely. Understanding
these correlations and then monitoring them closely on charts can often
signal the impact one asset class could have on the price trajectory of
another asset class. Knowing and applying these intermarket
relationships provide an invaluable additional toolset in a
trader’s/investor’s arsenal.Some of the key correlations that we shall
study in the upcoming chapters in this module are as mentioned below:

Correlation between the dollar and commodities

Correlation between the dollar and US interest rates

Correlation between one commodity and another

Correlation between commodity and bond prices/bond yields

Correlation between the dollar and bond prices/bond yields

Correlation between bond yields and interest rates

Correlation between bond yields and stocks

Correlation between interest rates and stocks

Correlation between the dollar and stocks

Correlation between commodities and stocks

Besides, we shall also study the business cycle and see how these asset
classes interact in a business cycle. With that said, it is time to conclude
this chapter. In the next chapter, we shall start our intermarket work,
wherein we shall study the correlation between the dollar and
commodities.

Dollar and Commodities Commodities, Bonds,

Next 18 Lessons
Chapter In this chapter, we shall study the
correlation that exists between the
dollar and commodities. From an
intermarket perspective, it is
important to understand the
correlation between the two and
to then monitor the trajectory of
these two asset classes on a real
time basis, given the influence they
can have on the trends of other
asset classes, namely bonds and
stocks.
Inflation, and Interest
Rates
9 Lessons
In this chapter, we will study the
correlation that exists between
commodities and bonds and the
crucial role that inflation and
interest rates play in influencing
this correlation. Trends in the
commodity and bond market can
and do influence the trajectory of
the stock market. As such, it is
pivotal for one to understand the
correlation between commodities
and bonds at various points in time
and then monitor this correlation
periodically on a real time basis.

Comments & Discussions in

FYERS Community

Responses
Kalaiselvan commented on August 6th, 2020 at 7:53 AM Reply

Thanks for covering Inter market analysis, this is very helpful and informative..I request you to conduct a
webnair if possible on the same

Abhishek Chinchalkar commented on August 6th, 2020 at 8:08 AM Reply

Hi Kalaiselvan, thank you for your valuable feedback. A lot more content would be coming on
Intermarket Analysis in the coming days. And yes, we surely will think of conducting a webinar
series on Intermarket Analysis in future.

Shreevardhan commented on August 26th, 2020 at 11:37 PM Reply

It was very informative and unique education. Thanks.

Abhishek Chinchalkar commented on August 27th, 2020 at 5:58 PM Reply

Hi Shreevardhan, thank you for your feedback!

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Home : Intermarket Analysis and Sector Rotation

Dollar and Commodities

In this chapter, we shall study the correlation that exists between the dollar and commodities. From an intermarket perspective, it is important
to understand the correlation between the two and to then monitor the trajectory of these two asset classes on a real time basis, given the
influence they can have on the trends of other asset classes, namely bonds and stocks.

Tejas Khoday (24th Jul, 20)

34 minutes read

In this chapter, we shallstudy the correlation that exists between the

dollar and commodities. Thegeneral correlation between these two asset
classeshas stood the test of time, although at times its strength and
magnitude has varied. From an intermarket perspective, it is important to
understand the correlation between the dollar and commodities and to
then monitor the trajectory of these two asset classes on a real time
basis, given the influence they can have on the trends of other asset
classes, namely bonds and stocks.

The inverse correlation between Dollar and Commodities

Historically, the dollar and commodities have exhibited an inverse

correlation between them. In other words, a rising dollar has typically
coincided with falling commodities prices, and vice versa. Of course, it
goes without saying that this correlation need not necessarily hold every
single day, as there would be several other factors that would individually
be impacting the dollar and commodities. That said, if you compare the
general price trajectory of these two asset classes, you will notice the
existence of an inverse correlation between them.

The question that you might ask is what impacts what? Is it the dollar that
impacts commodity prices, or is it commodity prices that impact the
dollar? Well, most of the times, it is the dollar that impacts the general
trajectory of commodity prices. However, after a certain point in time,
the roles can reverse. That is, commodity prices could start influencing
the trajectory of the dollar. Let us now understand each of these aspects,
one at a time.

International commodities are priced in Dollar terms

Allcountries import/export commodities. Nations import

commodities when they need them for consumption but are either
unable to produce them locally or the production is falling short of
consumption. On the other hand, nations export commodities when
they have surplus of them after meeting the domestic consumption
and as such want to earn export revenue from these surpluses.
When nations import commodities, they need to make payment for
theseimports. Similarly, when nations export commodities, they
would receive payment for the same. As these are international
transactions, things would be much simpler if:

There was a common currency in which two countries could

transact, and

Commodities were priced in a common currency

Let’s go back in history now. By the end of World War 1, the US had
become a major economic and military power. It had overtaken
England as the world’s largest economy, had the largest reserves of
gold in the world, and had a stable currency and a stable monetary
system. Also, by the end of World War 1, the US had become a net
creditor nation, meaning other nations owed more to the US than
the US owed to them. As a result, the dollar became a dominant
global currency. A lot of nations who had abandoned the Gold
Standard system back then started pegging the value of their
currency to the Dollar rather than to gold.Over time, the dollar
become the world’s reserve currency, a position that it still holds
today and is likely to do so in the foreseeable future. As such, when
it comes to international transactions, the dollar is a common
currency that is on one side of all trades in a vast majority of cases.
For the very same reason, a vast majority of international
commodities are priced in dollar terms, be it precious metals,
industrial metals, energy complex, or agro-commodities.

The dollar's influence on the trend of commodity prices

Now that we knowwhyglobalcommodities are mostly priced in

dollars and why global transactions are settled in dollars, let us
understand why the dollar’s trajectory influences commodity prices.

When the dollar strengthens, it means other currencies, in general,

are weakening. This makes it more expensive for holders of foreign
currencies to import commodities. For instance, let us assume that I
am a commodity importer from India.If the dollar has strengthened
against the rupee while commodity prices have not fluctuated
much, it means to import the same quantity of the commodity, I will
have to exchange more rupees to buy dollars (remember, global
payments are mostly done in dollars). As a result, my purchasing
power has reduced because of the dollar’s strength. Hence, as the
dollar strengthens, other things constant, demand for commodities
from holders of foreign currencies can decline. Due to such
expectations, commodity prices, in general, tend to fall during times
when the dollar is strengthening.

On the other hand, when the dollar weakens, it means other

currencies, in general, are strengthening. This makes it less
expensive for holders of foreign currencies to import commodities.
Taking the same example as above, if the dollar has weakened
against the rupee while commodity prices have not fluctuated
much, for an Indian commodity importer to import the same
quantity of the commodity, fewer rupees need to be exchanged to
buy dollars. As a result, the purchasing power of the Indian importer
would increase because of the dollar’s weakness. Hence, as the
dollar weakens, other things constant, demand for commodities
from holders of foreign currencies tends to increase. Due to such
expectations, commodity prices, in general, tend to rise during times
when the dollar is weakening.

Looking at it the other way, you will notice that when the dollar
strengthens, all else constant, commodities that are priced in
foreign currency terms will become more expensive to buy, and vice
versa. As a result, as the dollar strengthens, the demand for
commodities locally in foreign countries tends to weaken, and vice
versa. To understand this better, let us talk about dollar-priced gold
and rupee-priced gold. Back in August 2011, when the dollar-priced
gold hit a record high of $1,920/oz, the rupee-priced gold was
quoting around₹29,000/10gms. Fast forwarding to today, the
dollar-priced gold is at $1,800/oz while the rupee-priced gold is at
₹49,000/10gms. Notice the difference? See that while the dollar-
priced gold is still 5-10% below its 2011 highs, the rupee-priced
gold is 70% above the corresponding period high! The reason why
the rupee-priced gold has become so expensive relative to the
dollar-priced gold is because the dollar has strengthened
remarkably against the rupee during this period – from below 45
back then to above 75 today, which is a gain of over 65%.

Let us now summarize the dollar’s impact on commodities

As the dollar strengthens, all else constant, demand for commodities from
holders of foreign currency can be expected to weaken. As a result,
commodity prices tend to soften

As the dollar weakens, all else constant, demand for commodities from
holders of foreign currency can be expected to pick up. As a result,
commodity prices tend to strengthen

We will talk more about this in the coming sections, wherein we will
present historical charts to show the inverse correlation between
the dollar and commodities.

Late in a cycle, commodities could start influencing the

dollar's trend

Till now, we have talked about how the dollar impacts the price
trends of commodities. Can commodities impact the dollar? The
answer to this question is yes. Late in a business cycle (either the late
expansionary stage or the mid-to-late contractionary stage),
commodity prices can start influencing the dollar’s trend. Let us
explain how this can happen. In the mid-to-late expansionary stage
of a business cycle, as economic activity starts accelerating,
commodity prices tend to strengthen sharply because of high
demand for them. An important thing to keep in mind is that there is a
positive link between commodity prices and inflation.Rising commodity
prices are generally considered inflationary, especially because food
and energy prices are a key component of various price indices such
as the Consumer Price Index (CPI). Late in the expansionary stage of a
business cycle, as commodity prices heat up because of excess
demand, inflationary pressures mount. This in turn raises
expectations that, at some stage, the Federal Reserve (aka the Fed),
which is the US central bank, could increase interest rates to tame in
price pressures and prevent the US economy from overheating.
Such expectations can eventually start exerting upward pressure on
the dollar. Hence, late in an expansionary business cycle, it should
not come as a surprise to see the dollar starting to strengthen,
which indirectly stems from higher commodity prices.

The opposite is also true during mid-to-late contractionary stage.

During this period, as economic activity slows down, demand for
commodities starts declining, because of which commodity prices
decline.As commodity prices decline and economic activity reduces,
inflation starts decelerating as well. Slowing economic activity and
decelerating inflation raises expectations that, at some stage, the
Fed could start cutting rates to revive economic activity. Such
expectations can eventually start dragging the dollar southwards.
Hence, in a mid-to-late contractionary stage, it shouldn’t come as a
surprise to see the dollar starting to soften, which indirectly and
partly stems from commodity prices.

Let us now summarize the impact commodities can indirectly have

on dollar late in a business cycle:

In the late expansionary stage of a business cycle, commodity price uptrend

tends to accelerate, which coupled with an overheating economy raises
interest rate hike expectations from the Fed. This in turn can cause the
dollar to strengthen

In the mid-to-late contractionary stage of a business cycle, commodity

price downtrend tends to accelerate, which coupled with deceleration in
economic activity raises interest rate cut expectations from the Fed. This in
turn can cause the dollar to weaken

This loop of commodities being impacted by dollar’s trend for most

parts of the business cycle before eventually influencing the dollar
towards the end of business cycle often tends to keep repeating.

Dollar and the S&P GSCI

In the previous section, we talked about how and why the dollar impacts
the price trends of commodities. Let us now graphically see this
correlation between the dollar and commodities.

The chart below compares the price action of the Dollar Index
(represented by the orange line) and S&P GSCI (represented by the blue
line) between 2001 and 2008. Prior to July 2001, see that the DXY was in
an uptrend and S&P GSCI was in a downtrend. Later, notice that the DXY
made a major top in July 2001 and then a slightly lower top in January
2002. After the second top, the DXY started its major decline. Observe
that the second top in DXY in January 2002 precisely coincided with a
bottom in S&P GSCI. Post January 2002, the DXY entered a major
downtrend, which caused S&P GSCI to enter a major uptrend. This trend
between the dollar and commodities continued from early-2002 to mid-
2008. Meanwhile, notice the price action in 2005. During this year, the
DXY trended higher but so did S&P GSCI. This brings us to an important
point. The inverse correlation between the dollar and commodities need not
necessarily hold at all points in time. Occasionally, the correlation could break
and the two could move in the same direction for a certain period, as
there are various factors in play that could be affecting the individual
trends of the dollar and commodities. One must always keep this in mind
when looking at correlations between two asset classes.

The chart below compares the price action of the DXY (represented by
the orange line) and S&P GSCI (represented by the blue line) between
2008 and 2014. Notice that the DXY ended its 6-year downtrend and
bottomed out in March 2008. After a minor 2-3-month consolidation, the
DXY started trending higher. This bottom in DXY eventually caused S&P
GSCI to peak out and end its 6-year uptrend in June 2008. Post this, S&P
GSCI entered a steep and a swift downtrend. See that this downtrend in
S&P GSCI ended in February 2009, which coincided with the DXY
toppingout and starting to trend lower. From February 2009 till April
2011, the DXY was in a downtrend, which caused S&P GSCI to
strengthen during this period. Later, from April 2011 to July 2012, the
DXY was in an uptrend, which caused S&P GSCI to weaken during this
period. Between July 2012 and June 2014, notice that the sideways
movement in DXY coincided with a sideways movement in S&P GSCI.
Overall, observe how well the inverse correlation stood between the
dollar and commodities during this 6-year period.

The chart below compares the price action of the DXY (represented by
the orange line) and S&P GSCI (represented by the blue line) from 2014 till
date. See that after a 2-year consolidation, the DXY bottomed out in
April 2014 and started trending higher. The S&P GSCI topped out in June
2014 and started trending lower. The rally in DXY continued till
November 2015 before it topped out and started trending lower.
Eventually, S&P GSCI bottomed out in January 2016 before it started
trending higher. The region that is highlighted inside the shaded box
represents the period when the inverse correlation between the dollar
and commodities broke. During this period, notice that the dollar and
commodities rose simultaneously and then fell simultaneously.
Eventually however, the dollar’s decline started benefiting commodities,
as S&P GSCI resumed it rally from June 2017 till October 2018. Observe
that the DXY bottomed out in February 2018 and started trending
higher. Initially, S&P GSCI wasn’t impacted by the dollar’s strength as
both continued to rise simultaneously. However, as the DXY continued to
trend higher, S&P GSCI eventually succumbed to the dollar’s strength
and topped out in October 2018. From October 2018 till March 2020,
the DXY was in an uptrend, which caused S&P GSCI to trend lower. The
DXY topped out in March 2020 and has been trending lower since then.
This in turn caused S&P GSCI to bottom out in April 2020, which has
been in an uptrend since then.

Notice how strongly the inverse correlation between the dollar and
commodities has played out since the turn of the century. Occasionally,
the correlation tends to break, and one needs to be aware of this.
However, broadly speaking, the inverse correlation between the two
tends to hold very well. From this, it can be concluded that:

A rising dollar, as it tends to exert downward pressure on commodity prices, is

disinflationary

A falling dollar, as it tends to exert upward pressure on commodity prices, is

inflationary

Dollar and Crude oil

Earlier, we talked about the correlation between the dollar and

commodities using S&P GSCI. In the next few sections, we shall look at
how the correlation holds between the dollar and individual
commodities. Of course, there are various commodities that are traded
around the world. We won’t be looking at each one of them. Instead, we
will just look at four key commodities, one from each of the four groups,
and compare them with the dollar. These four commodities are crude oil,
copper, soybean, and gold. In this section, we shall look at the correlation
between the dollar and crude oil.

Crude oil is one of the most watched, most used, and most traded
commodities in the world. It is also one of the most important
commodities of all as it affects the livelihood of virtually everyone on this
planet. It is a commodity whose price is closely monitored by central
banks and governments around the world, given the widespread impact
it has on inflation and a nation’s trade balance. Rising oil prices could
suggest that global economic conditions are strengthening. However, too
high a price can pose problems and lead to a surge in price pressures. On
the other hand, falling oil prices are beneficial to consumers as well as to
several countries, especially those who rely on oil imports to meet the
demand requirements. However, too low a price can pose problems to
exporting nations while also raising worries over the health of the global
economy. Hence, a stable oil price is usually preferred by most nations.
Let us compare how oil priceand the dollar correlate to each other.

The chart above compares the price action of the DXY (represented by
the orange line, LHS) and Brent crude oil (represented by the blue line,
RHS) from 2000 till date. The objective of this chart is to show the major
trend turning points between the two. See that the major top in DXY in
January 2002 coincided with a major bottom in oil during the same
period. From here on until June 2008, DXY fell while oil rose. The bottom
in DXY in June 2008 and its subsequent rally coincided with a top in oil
and its subsequent decline. From March 2009 to April 2011, see that the
decline in DXY benefited crude oil, which ended its steepest fall in history
and rallied strongly during this period. Between April 2011 and April
2014, notice that the higher low in DXY coincided with a lower high in oil.
From April 2014, the DXY started a powerful and a swift rally, which
coincided with oil prices plummeting during this period. An interesting
thing to note here is that oil prices bottomed in January 2016, which was
much earlier than the peak in DXY, which topped out later that year in
December. This highlights that the lead-lag times can occasionally vary.
From December 2016 till February 2018, the DXY fell, which benefited
oil prices. The DXY eventually bottomed in February 2018 and started
rallying. This rally in DXY subsequently ended the oil price rally in
October 2018 (again notice the lead-lag time). From here on until March
2020, DXY rose while oil fell. Since March 2020, observe that the fall in
DXY has coincided with a rise in oil prices.Meanwhile, also noticethe
shaded regions. These refer to periods when the inverse correlation
between DXY and oil broke and the two moved in the same direction.

It can be seen from the price action over the past two decadesthat the
dollar and crude oil share a nice inverse correlation between them. That
is, a strengthening dollar has a negative impact on oil prices, and vice
versa. Occasionally, as we saw above, the correlation between the two
can break for a certain period. Another thing we observed was that the
lead-lag time between a top in one and a bottom in the other can at times
vary, which is very important to keep a note of. That said, from a longer-
term perspective, the inverse correlation between the dollar and crude
oil holds strong.

Dollar and Copper

Just like crude oil, copper is also a bellwether commodity. It is often

called as ‘Dr. Copper’ because of its widespread usage across industries as
well as in the construction and home building sector. The price of copper
can tell a lot about the health of the global economy. Rising copper prices
usually coincide with strengthening economy. This is because when
economic conditions strengthen, industrial and construction activity
tend to pick up, which boosts demand for copper, thereby lifting its price.
Similarly, falling copper prices usually coincide with weakening economy.
This is because when economic conditions weaken, industrial and
construction activity tend to slowdown, which reduces demand for
copper, thereby dragging down its price. Supply-side factors can also
influence the price trajectory of copper. For instance, any unexpected
labor unrest issue or natural disastersin major copper-mining regions
could hamper production and thereby lift prices. Let us compare how
copper price and the dollar correlate to each other.

The chart above compares the price action of the DXY (represented by
the orange line) and US Copper (represented by the blue line) from 2000
till date. The objective of this chart is to show the major trend turning
points between the two. Observe that the DXY bottomed in March 2008,
precisely in the same month when copper topped out. From March 2008
till February 2009, the DXY strengthened, causing copper prices to head
south during this period. However, copper prices bottomed a couple of
months prior to the peak in the DXY. From February 2009 till April 2011,
the DXY was in a downtrend. During this 2-year period, copper prices
rallied sharply before topping out in January 2011. See yet again that
copper prices turned three months before the dollar turned. Then, from
April 2011 to December 2016, the DXY trended higher. During this
period, copper prices were in a steady downtrend, which ended in
January 2016. See that copper bottomed out nearly a year before the
DXY topped out and see the decoupling in the second half of 2016 – both
DXY and copper mostly headed higher during this period.The decline in
DXY from December 2016 continued till January 2018, during which
time copper prices headed higher. The DXY then bottomed in January
2018 and rallied until March 2020. See this this 2-year rally in DXY
precisely coincided with a 2-year decline in copper prices. Since March
2020, the DXY has inched lower, which has helped copper prices to
recovery strongly.

Overall, we could observe from the above chart that there is a strong
inverse correlation between the dollar and copper prices as well.
Interestingly, sometimes, there is a tendency for copper to turn ahead of
the dollar, as we saw above.

Dollar and Soybean

Soybean is one of the most traded as well as one of the most watched
agricultural commodities. It is widely used across the world both for
human consumption and as a source of protein for animal feeds. As it is
priced in dollars, the price of soybean is impacted by the dollar’s strength.
Let us compare how soybean price and the dollar correlate to each other.

The chart above compares the price action of the DXY (bottom panel)
and CBOT Soybean (top panel) from 2000 till date. The objective of this
chart is to show the major trend turning points between the two.
Observe that the major downtrend in the dollar from January 2002 till
March 2008 coincided with a major uptrend in soybean prices during this
same period. The DXY bottomed out in March 2008 and rallied for the
next one year till March 2009. During this 1-year bull market in DXY,
soybean prices corrected sharply, retracing a significant portion of their
2002-2008 advance. After topping out in March 2009, the DXY was in a
downtrend till April 2011, albeit with a great bout of volatility. During
this 2-year downtrend in DXY, soybean prices headed higher, recovering
entirely from the prior fall. From April 2014 till December 2016, the DXY
strengthened notably, causing soybean prices to fall sharply during this
period.

Meanwhile, notice in the chart the shaded regions. These indicate

periods when the inverse correlation between the DXY and soybean did
not hold. An important this to keep in mind is that as soybean is an agro-
commodity, it is at times heavily influenced by supply-side factors and
global weather patterns. As a result, during these periods, the inverse
correlation between the two may not hold very well. That said, from a
longer-term perspective, the inverse correlation between the dollar and
soybeanhas held strongly.

Dollar and Gold

Gold is one of the most eyed commodities of all. In fact, it wouldn’t be

wrong in saying that gold is as much of a currency as it is a commodity.
Before currency notes and coins came into circulation, gold was a
standard medium of exchange for several centuries. It was and still is
considered an ideal store of value. While most other commodities are
primarily used for consumption, gold is heavily used as an investment
vehicle and in the form of jewelry. Because of its scarce supply, the value
of gold has steadily appreciated over the years. Gold is often used as a
hedge against inflation and tends to perform strongly when currencies
are being devalued. Gold is also used as a hedge against tail risks and
tends to perform well during times of heightened volatility and risk
aversion in the markets. Besides equities, fixed income instruments, cash,
and real estate, gold also forms an important part of an investor’s
portfolio that is used to diversify risks. Because gold is priced in dollars, it
tends to be extremely sensitive to dollar’s movement. In fact, gold is one
of the most sensitive commodities to the dollar’s fluctuation. Major turns
in the dollar usually tends to coincide with major turns in gold prices as
well, precisely at more or less the same time. Unlike other commodities,
where supply-side developments can strongly influence their prices and
cause them to decouple from the dollar, gold is not much impacted by
supply-side developments. Instead, activity on the demand-side is what
tends to drive gold prices the most. Let us compare how gold and the
dollar correlate to each other.

The chart above compares the price action of the DXY (bottom panel)
and Gold (top panel) from 2000 till date. The objective of this chart is to
show the major trend turning points between the two. Observe that the
major bear market in DXY from January 2002 to March 2008 coincided
with a major bull market in gold, during which time gold prices nearly
quadrupled in value. The DXY bottomed out in March 2008 and rallied
until March 2009. This caused gold to top out in March 2008 and decline
until October 2008. Notice that gold bottomed out nearly six months
before the DXY topped out. In fact, during these 6 months, gold
recovered from most of its previous drop and was back near its prior
highs. The breakdown in the inverse correlation between gold and DXY
during this period was due to the unprecedented volatility in global
markets as a result of the collapse of the Lehman Brothers in September
2008, which caused a flight to safety and subsequently benefited gold.
For the next couple of years from March 2009 to April 2011, the DXY
was in a bear market, which played a key role in propelling gold prices
higher. During the 2.5-year period between October 2008 and August
2011, gold prices nearly tripled in value. The DXY bottomed in April
2011 and entered a bull market, which lasted until December 2016.
During this 5.5-year bull market in the DXY, gold prices came under
increasing pressure, nearly halving in value during this time. From
December 2016 till February 2018, a weakening DXY caused gold to
recover, albeit at a slower pace.

Notice the portions that are marked within the shaded regions. These
reflect periods when the inverse correlation between gold and DXY
broke. See that between August 2018 and March 2020, both gold and
DXY moved higher. Since then however, the inverse correlation between
them has resumed as gold has been heading higher since March 2020
while the DXY has been heading lower.

Of all the commodities, gold tends to have the strongest inverse

correlation with the DXY. Hence, it is important to keep a track of the
price trajectory of both these assets. A weakening dollar is inflationary
and as gold is often used as a hedge against inflation, it tends to perform
well during periods when the dollar is weakening, and vice versa.

Gold often tends to lead Commodities

As said earlier, gold is one of the most sensitive commodities to the

dollar’s fluctuation. Major turns in the dollar usually tends to coincide
with major turns in gold prices as well, precisely at more or less the same
time. While gold usually tends to move in the same direction as other
commodities in general, there is a tendency for gold to turn ahead of
other commodities. That is important tops and bottoms in gold usually
precede important tops and bottoms in other commodities. Let us
illustrate this using the chart below:

The above chart compares the price action between gold (bottom panel)
and S&P GSCI (top panel) over the past two decades. The objective of
this chart is show that in vast majority of cases, gold often tends to turn
before other commodities, in general, do. Notice above that gold
bottomed in March 2001 and started rising. The S&P GSCI bottomed 9
months later in December 2001 and started rising. The primary bull
market in gold hit its first intermediate hurdle in May 2006, causing the
metal to enter a corrective mode until October 2006. The S&P GSCI
followed suit 2 months later as it hit an intermediate peak in July 2006
and underwent a correction until January 2007. After rallying from
October 2006, gold hit a second intermediate hurdle in March 2008 and
underwent a correction that lasted till October 2008. The S&P GSCI yet
again followed suit as it rallied from January 2007 till June 2008.
However, unlike gold, which underwent an intermediate correction
between March 2008 till October 2008, the S&P GSCI underwent a very
deep correction from June 2008 till February 2009. Subsequently, as
gold resumed its primary bull market from October 2008, the S&P GSCI
also resumed the rally from February 2009. However, this time, the S&P
GSCI topped out earlier in April 2011, whereas gold topped out a few
months later in August 2011.

Notice that in February 2013, gold broke a rising trendline support,

which signaled at lower prices. If history were to go by, the move lower in
gold was a warning that the S&P GSCI could top out in the months ahead.
This did happen in June 2014, when the S&P GSCI broke below a rising
support line, signaling lower prices ahead. That said, see that there was a
significant lag here. Gold price broke down in February 2013, while the
S&P GSCI broke down in June 2014 – a lag of 16 months! The two fell in
the subsequent months, with gold bottoming in November 2015 and the
S&P GSCI bottoming in January 2016. From here on, both gold and the
S&P GSCI rallied. However, notice the portion that is marked in the
shaded region. It can be seen that gold and the S&P GSCI diverged during
this period, when gold prices rose while other commodities, in general,
fell. Post March 2020, the positive correlation between the two has
resumed.

The purpose of talking about this is to show that gold often acts as a
leading indicator of commodities. It is important to know the existence of
such relationships when it comes to trading and investing.

Using Commodity ratios to gauge market sentiment

Now that we have talked about how the dollar influences commodity
prices and how gold prices often tend to lead commodity prices, it is time
to move on. Now, we shall focus on the macro-economic implications of
commodities, primarily by using ratio analysis of one commodity with
another.

Gold to Crude oil ratio

Here, we shall talk about how to use the gold to crude oil ratio to gauge
market sentiment. Before we proceed, keep in mind the following things:

Gold is a safe haven asset that tends to perform well during times of heightened
volatility, economic uncertainty, and currency debasement. During times of
economic strength, demand for gold tends to decline

Crude oil is a commodity that rises in value during times of economic strength
and falls during times of economic weakness. Sometimes however, supply-side
disruptions can cause oil to spike even during times of economic weakness,
though such spikes have historically not lasted for prolonged periods of time

Because rising oil price is inflationary and because gold is often used as an
inflation-hedge, rising oil price can benefit gold if inflation becomes a threat, and
vice versa

Ratio analysis tells nothing about the absolute direction of two assets, but just
their relative direction (i.e. whether one is outperforming the other or
underperforming)

The above chart compares Gold to Crude oil ratio (top panel) with the
Dow Jones Industrial Average (bottom panel). In the ratio, gold is in the
numerator while crude oil (Brent) is in the denominator. At present, the
ratio value is around 40, meaning 1 ounce of gold is equivalent to 40
barrels of crude oil. A rising ratio means gold is outperforming oil
because of which more quantities of crude oil are needed to buy 1 ounce
of gold, while a falling ratio means oil is outperforming gold because of
which fewer quantities of crude oil are needed to buy 1 ounce of gold.

See that for most periods, the ratio tends to gradually trend lower.
However, there is a tendency for the ratio to spike for brief periods of
time. A downward trending ratio is a sign that economic conditions are
strengthening, which typicallycauses crude oil to outperform gold. On
the other hand, a rising ratio is a sign that economic conditions are
weakening, which typically causes gold to outperform crude oil.In the
above chart, notice the regions marked inside shaded boxes. These show
the periods when there was a spike in the ratio, meaning gold swiftly
outperformed crude oil. When the ratio spikes, risk assets usually
experience strong bouts of volatility. Notice how the Dow Jones
Industrial Average (DJIA), which is one of the most tracked equity indices
around the world, fared during periods of strong spikes in the gold/crude
oil ratio.

The above chart suggests that Gold/crude oil ratio can be used to
monitor the prevailing risk appetite of market participants. A steady fall
in the ratio is usually accompanied by strong risk appetite, which is
generally bullish for risky assets; whereas periods when the ratio is
breaking out or giving spikes is usually accompanied by risk aversion,
which is generally bearish for risky assets.

Gold to Copper ratio

Now, we shall talk about how to use the gold to copper ratio to gauge
market sentiment. Before we proceed, apart from what was said about
gold earlier, keep in mind the following things:

Copper is barometer of global economic health because of its widespread usage

in construction activities, electrical and electronic appliances, vehicle
components etc.

As global economic conditions strengthen, demand for copper rises and

subsequently lifts its price, and vice versa

China accounts for over half of the global demand for copper. Hence, economic
health of China has a strong bearing on the price trends of copper

Sometimes, supply-side disruptions can cause copperto spike even during time of
economic weakness, though such spikes have historically not lasted for prolonged
periods of time

The above chart compares Gold to Copper ratio (top panel) with the Dow
Jones Industrial Average (bottom panel). In the ratio, gold is in the
numerator while copper (COMEX) is in the denominator. At present, the
ratio value is around 625, meaning 1 ounce of gold is equivalent to 625
pounds of copper. A rising ratio means gold is outperforming copper
because of which more quantities of copper are needed to buy 1 ounce of
gold, while a falling ratio means copper is outperforming gold because of
which fewer quantities of copper are needed to buy 1 ounce of gold.

In the above chart, notice that the ratio gradually trends lower most of
the times. This indicates periods when copper is outperforming gold,
which is a sign of economic strength. Notice how equities tend to rise
during such periods. On the other hand, also observe the shaded regions
in the ratio, which reflect periods when the ratio is spiking or is breaking
out. This indicates periods when gold is outperforming copper, which is a
sign of economic weakness. Notice how equities tend to come under
pressure when the ratio is spiking.

The above chart suggests that Gold/copper ratio can be used to monitor
the prevailing risk appetite of market participants. A gradual fall in the
ratio is usually accompanied by strong risk appetite, which is generally
bullish for risky assets; whereas periods when the ratio is breaking out or
giving spikes is usually accompanied by risk aversion, which is generally
bearish for risky assets.

Some interesting Commodity-Currency correlations

In this section, we shall talk about some interesting correlations that

exist between a commodity and a currency pair. We will show the
correlations using price charts wherein we shall compare movements in a
commodity with that in a correlated currency pair. So, let us get started.

NYMEX Crude oil and USD/CAD

There is a very strong inverse correlation between NYMEX crude oil and
USD/CAD. That is, when one rises, the other tends to fall, and vice versa.
The reason for the existence of this correlation is because Canada is a
major producer and exporter of crude oil, with a bulk of Canada’s oil
going to the US. As per the government of Canada, a whopping 3.5
million barrels or 96% of its total oil exports went to the US alone in
2018. Because of the enormous volumes of oil exported to the US, the
Canadian Dollar is verysensitive to the price trajectory of crude oil, given
the strong inflows of the Canadian unit it generates. As such, rising oil
prices lead to strong inflows of Canadian Dollars, thereby causing it to
strengthen versus the US Dollar. On the other hand, falling oil prices
reduces inflows of Canadian Dollars, thereby causing it to depreciate
versus the US Dollar.

The chart above compares the price action of NYMEX Crude oil (top
panel) with that of USD/CAD (bottom panel) since 1994. Observe how
the two tend to move in the opposite direction. Closely observe the
arrow in the top panel with the corresponding arrow in the bottom panel.
You will notice that a top in one usually coincides with a bottom in the
other, and vice versa. See that there is often a tendency for USD/CAD to
top out or bottom out just prior to crude oil bottoming out or topping
out. Hence, occasionally, movement in USD/CAD can give signals about
what could happen in crude oil. One can use this correlation between the
two to his/her advantage.

Gold and AUD/USD

From a long-term perspective, there has been a positive correlation

between Gold and AUD/USD. The two tend to move in sync most of the
time. The reason for the existence of this correlation is because Australia
is a major producer and exporter of the yellow metal. Itis the second
largest gold producing nation in the world and gold forms a major
component of the nation’s export bill. In 2019, it produced a record 325
tons of gold, which is equivalent to around 9% of the global output.
Because of this, the Australian Dollar is notably impacted by the
direction of gold prices.

The chart above compares the price action of Gold (top panel) with that
of AUD/USD (bottom panel) since 2000. Observe how the two tend to
move in the same direction. Closely observe the arrow in the top panel
with the corresponding arrow in the bottom panel. You will notice that a
top in one usually coincides with a top in the other, and vice versa.
Meanwhile, see the region highlighted in the shaded box. This represents
a period when the positive correlation broke, as gold prices strengthened
while AUD/USD weakened. A major reason for the breakdown of the
correlation during this period was a slowing Chinese economy. China is
Australia’s biggest trading partner and in 2019, it accounted for nearly a
third of Australia’s exports revenue. Consequently, a slowdown in China
has had a negative impact on the Aussie Dollar. Since March 2020
however, the correlation has again turned positive. While the correlation
can break from time to time, from a longer-term perspective, it tends to
hold very well. Hence, one must continue monitoring the correlation
between gold and AUD/USD. If it stays positive going forward, then one
can use this correlation to his/her advantage.

Gold and USD/JPY

There is a negative correlation between gold and USD/JPY. That is, a rise
in one is usually accompanied by a fall in the other, and vice versa.
Because the two move in the opposite direction, it means gold and the
Japanese Yen usually tend to move in the same direction. The reason why
this happens is because of global risk flows. We know by now that during
times of risk aversion, gold tends to perform well; and during times of
economic strength, gold tends to underperform. Currencies also exhibit
such a relationship. There are currencies that benefit during times of
economic strength because foreign money tends to flow into these
nations to seek growth. Examples include commodity and emerging
market currencies. Then there are some that benefit during times of
economic weakness and volatility because foreign money tends to flow
into these nations to seek refuge in safer assets, such as government bills
and bonds. The Japanese Yen is one such currency that tends to
strengthen during times of economic weakness and volatility. As a result,
gold and Yen often tend to move in sync.

The chart above compares the price action of Gold (top panel) with that
of USD/JPY (bottom panel) since 2000. Observe how the two tend to
move in the opposite direction. Closely observe the arrow in the top
panel with the corresponding arrow in the bottom panel. You will notice
that a top in one usually coincides with a bottom in the other, and vice
versa. Meanwhile, see the region highlighted in the shaded box. This
represents a period when the inverse correlation broke, as gold prices
strengthened while USD/JPYalso headed higher.

Copper and USD/CLP

There is an inverse correlation between copper and USD/CLP. That is, a

rise in one is usually accompanied by a fall in the other, and vice versa.
CLP stands for Chilean Peso and is the currency of Chile. The reason for
the existence of this correlation is because Chile is the largest producer
and exporter of copper in the world. In 2019, its copper mine production
is estimated to have stood at 5.6 million tons, which is just less than a
third of the global copper production. As per a report by Sustainable Copper,
copper mining has accounted for an average of 10% of Chile’s GDP over
the past two decades. As copper exports contribute a lot to Chile’s export
revenues, the Chilean peso is notably impacted by the direction of
copper prices.

The chart above compares the price action of Copper (top panel) with
that of USD/CLP (bottom panel) since 2004. Observe how the two tend
to move in the opposite direction. Closely observe the arrow in the top
panel with the corresponding arrow in the bottom panel. You will notice
that a top in one usually coincides with a bottom in the other, and vice
versa.

Commodities, Bonds, Bonds and Stocks

Next Inflation, and Interest 7 Lessons

Chapter Rates
9 Lessons
In this chapter, we will explain the
correlation between stocks and
bonds and the role interest rates
In this chapter, we will study the play in impacting stock prices. It is
correlation that exists between important to understand how the
commodities and bonds and the two correlate to each other and
crucial role that inflation and keep a track of how that
interest rates play in influencing correlation is evolving over time.
this correlation. Trends in the Often, change in the direction of
commodity and bond market can bonds can influence the direction
and do influence the trajectory of of stocks as well
the stock market. As such, it is
pivotal for one to understand the
correlation between commodities
and bonds at various points in time
and then monitor this correlation
periodically on a real time basis.

Comments & Discussions in

FYERS Community

Responses
Akshat Rohatgi commented on August 6th, 2020 at 9:00 PM Reply

Interesting!

Abhishek Chinchalkar commented on August 7th, 2020 at 8:02 AM Reply

HI Akshat, thank you!

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Home : Intermarket Analysis and Sector Rotation

Commodities, Bonds, Inflation, and Interest

Rates
In this chapter, we will study the correlation that exists between commodities and bonds and the crucial role that inflation and interest rates
play in influencing this correlation. Trends in the commodity and bond market can and do influence the trajectory of the stock market. As such,
it is pivotal for one to understand the correlation between commodities and bonds at various points in time and then monitor this correlation
periodically on a real time basis.

Abhishek Chinchalkar (5th Aug, 20)

26 minutes read

In this chapter, we will study the correlation that exists between

commodities and bonds and the crucial role that inflation and interest
rates play in influencing this correlation. Trends in the commodity and
bond market can and do influence the trajectory of the stock market. As
such, it ispivotal that one understands the correlation between
commodities and bondsat various points in time and then monitorsit
periodically on a real time basis.

In the first chapter, we talked about the relationship between bond

prices and bond yields. We saw that the two always move in the opposite
direction. In this chapter, we will talk about bonds from the perspective
of yields rather than prices. Keep in mind that if bond yields, in
general,are rising, it means bond pricesare falling, and vice versa. Also
keep in mind that when we say a certain type of relationship exists
between bond yields and an asset class, it implies an existence of
opposite relationship between bond prices and that asset class.

High Inflation and interest rates

Inflation and interest rates are quite correlated to each other. In fact, the
latter is used by government officials of a nation as a tool to control the
level of inflation in an economy. Generally speaking, inflation is not
always a bad thing. In fact, a moderate level of inflation in a growing
economy is actually a healthy sign because it indicates rising demand for
various goods and services.This boosts employment opportunities and
wage rate, which in turn boosts consumer spending. However, too much
inflation can pose a threat to economic stability as it reduces the
purchasing power of people, hurts savings as real rates reduce, and
discourages companies from investing in capital and labour.

The level of inflation in an economy is linked to the level of money supply

in that economy. Money supply means the amount of money that is in
circulation in an economy. Over the long-term, there is a positive
correlation between the two. That is, as the level of money supply in the
economy increases, the prices of goods and services, in general, tend to
increase. The reason why this happens is because there would too much
money chasing a limited amount of goods and services, causing their
prices to go up. Meanwhile, the opposite is also true when the level of
money supply in the economy reduces.

In an economy, the institute that most influences the level of interest

ratesand money supply is the central bank of that economy. One of the
major mandates of most central banks around the world is to maintain
stable prices (i.e. inflation). To ensure the attainment of this objective,
central banks use a tool at their disposal called the monetary policy.
Monetary policy helps a central bank to directly influence the level of
money supply in the economy, thereby helping it to achieve
macroeconomic objectives. At times when inflation rises too much to
pose a threat to economic stability, central banks tend to increase their
key policy interest rates to tame inflationary pressures. Traditionally,
central banks tend to do the following to tackle high inflation in an
economy:

Raise the Repurchase rate: This is the rate at which commercial banks borrow
money from the central bank. As the central bank raises the Repurchase
rate, the cost of borrowing for commercial banks goes up. Subsequently,
commercial banks tend to pass on such higher costs to their customers by
raising the interest rates they charge on various types of loans. This in turn
makes loans more expensive, which tends to hurt the demand for them and
thereby restrict the quantum of money supply in the economy.

Raise the Reverse Repurchase rate: This is the rate at which commercial
banks park their surplus funds with the central bank. As the central bank
raises the Reverse Repurchase rate, the incentive to park idle money with
the central bank increases because of the higher rate of interest. And as
commercial banks park a greater portion of their excess reserves with the
central bank, the quantum of money supply in the system reduces.

Raise the Reserve requirement ratios: This refers to the amount of cash or
liquid assets that commercials banks must maintain in hand at all times.
During periods of high inflation, the central bank could increase the reserve
requirement ratios. Doing so means commercial banks will have to maintain
a greater amount of deposits in the form of reserves, thereby reducing the
amount of disposable funds that banks could give out as loans. This in turn
helps in reducing the amount of money in circulation.

Sell G-Secs usingOpen market operations: This refers to the purchase and/or
sale of government securities (G-Secs) in order to control the level of
liquidity in the economy. During times of high inflation, a central bank could
sell government securities in the market and in turn suck money from the
market, thereby draining excess liquidity from the economy.

By using any or a combination of the above tools, the amount of money in

circulation (i.e. the money supply) tends to reduce. And as there would
now be fewer money chasing the same amount of goods and services,
inflationary pressures gradually tend to decelerate as well.

Let us conclude by highlighting the key learnings from this section:

A central bank uses monetary policy at its disposal to influence the level of money
supply in the economy

When the level of inflation in an economy poses a threat to economic stability, a

central bank adopts a contractionary monetary policy

In a contractionary monetary policy, central banks increase interest rates/reserve

ratios/sell G-Secs with the aim of reducing the level of money supply in the
economy

As the level of money supply in the economy reduces, consumer and corporate
spending tend to reduce and savings tend to go up, leading to slowdown in
economic activity and taming in inflationary pressures

Low inflation/deflation and interest rates

In the previous section, we talked about how high inflation affects the
level of interest rates in an economy. We saw that when inflation in an
economy gets too high to start posing a threat to economic stability, the
central bank of that nation would adopt a contractionary monetary
policy to cool down the economy and reduce inflationary pressures. Let
us reverse the role now. What if the level of inflation in an economy gets
too low or what if the economy experiences a deflation? We shall discuss
about that in this section.

We know that inflation is a situation in which the prices of goods and

services in an economy are rising. If the rise in the prices of goods and
services in an economy is occurring at a slower, or decelerating, rate, the
situation is called disinflation. On the other hand, if prices of goods and
services in an economy are declining, the situation is called deflation.

When an economy flirts with deflation (too low an inflation) or falls into a
deflation, there can be a reduction in consumer spending on anticipation
that goods and services will get more cheaper going forward. This in turn
can hamper businesses, reduce capital expenditure, reduce wages, and
increase unemployment. Deflation also tends to tighten the money
supply by increasing real interest rates, which encourages consumers
and businesses to save more. Subsequently, reduced spending from
consumers and businesses will take a heavy toll on the economy. As such,
when inflation gets too low or when an economy falls into a deflationary
spiral, the central bank of a country that experiences such a situation
tends to aggressively decrease their key policy interest rates to try and get
the economy out of the deflationary spiral. If there is limited room to
lower interest rates or if conventional policy measures are not having the
desired effect on the economy, central banks could also resort to
unconventional policy measures such as printing money and increasing
the monetary base. Central banks tend to do the following to tackle very
low inflation/deflation in an economy:

Lower the Repurchase rate: As the central bank lowers the Repurchase rate,
the cost of borrowing for commercial banks reduces. Subsequently,
commercial banks tend to pass on such lower costs to their customers by
reducing the interest rates they charge on various types of loans. This in turn
makes loans attractive, which tends to boost the demand for them and
thereby increase the quantum of money supply in the economy.

Lower the Reverse Repurchase rate: As the central bank lowers the Reverse
Repurchase rate, the incentive to park idle money with the central bank
reduces because of the lower rate of interest. And as commercial banks park
less of their excess reserves with the central bank, there would be a greater
quantum of money supply to give out as loans, thereby boosting money
supply in the economy.

Lower the Reserve requirement ratios: During periods of very low

inflation/deflation, the central bank could reduce the reserve requirement
ratios. Doing so means commercial banks will have to maintain a smaller
amount of deposits in the form of reserves, thereby increasing the amount of
disposable funds that banks could give out as loans. This in turn helps in
increasing the amount of money in circulation.

Purchase G-Secs using Open market operations: During times of very low
inflation/deflation, a central bank could purchase government securities in
the market and in turn issue currency, thereby increasing liquidity in the
economy.

Print money: Central banks could also print money and infuse it into the
economy by purchasing G-secs as well as other short-term and long-term
securities from commercial banks and other entities. This expands the
amount of money that such institutions have at their disposal, which they
can then utilize to issue loans to consumers and businesses. Furthermore, by
buying long-term G-Secs and other securities, the yields on such
instruments go down, which tends to lower long-term interest rates as well.
All this in turn helps to boosts the level of liquidity and money supply in the
economy.

By using any or a combination of the above tools, the amount of money in

circulation tends to increase. As short-term and long-term loans become
cheaper, consumer and corporate borrowings tend to increase, thereby
aiding in getting the economy kickstarted again. And as the economy
kickstarts, deflationary pressures tend to reduce.

Let us conclude by highlighting the key learnings from this section:

When the level of inflation in an economy is too low or if deflationary forces are
mounting, a central bank adopts an expansionary monetary policy

In an expansionary monetary policy, central banks reduce interest rates/reserve

ratios/buy G-Secs/print money with the aim of increasing the level of money
supply in the economy

As the level of money supply in the economy increases, the cost of borrowing
reduces. This boosts consumer and corporate spending and reduces the incentive
to save, thereby leading to a pickup in economic activity and reduction in
deflationary pressures

Targeting the ideal inflation rate

Several central banks around the world set a specific target level for
inflation rate in their economy. The RBI aims to keep inflation, as
measured by the Consumer Price Index (CPI), within a range of 2% and 6%
with a target level of 4%. What this means is the RBI would prefer the
annual CPI rate to be close to 4%. If the annualized CPI consistently
prints above the upper comfort zone of 6% for a few months, it would be
a cause of concern for the RBI and would increase market expectations
of interest rates hikes from the RBI. Similarly, if the annualized CPI
consistently prints below the lower comfort zone of 2% for a few months,
it will increase market expectations of interest rates cuts from the RBI.
Meanwhile the US Federal Reserve targets to keep the inflation rate, as
measured by the Personal Consumption Expenditure(PCE), at 2%.

In conclusion, the level of inflation in an economy has a strong bearing on the level of
interest rates in that economy. During times of high inflation, interest rates tend to go
up. On the other hand, during times of very low inflation or deflation, interest rates tend
to go down.

You might be wondering is this really important to understand. The

answer is yes. Inflation influences the trajectory of interest rates. And
expectations of the future trajectory of interest rates have a strong
bearing on bond yields/prices. Also, commodity prices often act as a good
indicator of inflation in the economy. Hence, the direction in which
commodity prices are heading can tell a lot about how inflation could be
panning out. In the coming sections, we shall study more about this.

Correlation between commodities and interest rates

As said above, commodities often tend to act as astrong indicator of inflationary

trends. Rising commodity prices are usually followed by a rise in inflationary pressures,
while falling commodity prices are usually followed by a decline in inflationary
pressures. In other words, commodity prices share a positive correlation
with the rate of inflation. The reason why this happens is because of the
usage of commodities as raw materials in the production of goods and
products as well as in their transportation from one place to another.
Take the example of crude oil. Crude oil is a crucial commodity that is
used as a fuel in the manufacturing of various goods and products, is used
for power generation, is used for heating etc. Besides, the various
products of crude oil such as petrol, diesel, and jet fuel are used as fuel in
vehicles, trains, ships, planes etc., which transport goods and products
from one place to another. As such, if there is a steady increase in the
price of crude oil, the cost of manufacturing and transportation will
increase. The producers, in turn, could pass on these higher costs to
consumers, which in turn could fuel inflation. The opposite is also true
when there is a steady drop in the price of crude oil, which in turn could
fuel disinflation.

The above chart compares annualized change in consumer inflation in

the US (LHS, blue line), as measured by the CPI, with the price of Brent
crude oil (RHS, red line) since the late 1980s. It can be seen that the two
mostly trend in the same direction. That is, periods when oil prices
steadily rise are accompanied by increase in inflationary pressures, while
periods when oil prices steadily drop are accompanied by decrease in
inflationary pressures.

So far in this section, we have seen that rising commodity prices are
inflationary, while falling commodity prices are disinflationary.
Meanwhile, in the previous section, we saw that during periods of high
inflation, central banks tend to increase interest rates, while during
periods of low inflation or deflation, central banks tend to decrease
interest rates. From this, we can say that:

Because a steady rise in commodity prices is inflationary, periods when

commodity prices are steadily climbing are usually accompanied by rising interest
rates

Because a steady decline in commodity prices is disinflationary/deflationary,

periods when commodity prices are steadily declining are usually accompanied by
falling interest rates

The above chart compares the Effective Federal Funds rate (LHS, blue
line) with the price of Brent crude oil (RHS, red line). It can be seen that
during periods when oil prices are strengthening, interest rates in the US
generally tend to move higher because of the inflationary impact of rising
oil prices. Similarly, periods when oil prices are weakening tend to give
room to central banks to cut interest rates as inflationary pressures
recede. Having said that, keep in mind that inflation plays an important
role in influencing the trajectory of interest rates. If rising (falling) oil
prices are not fuelling in inflationary (disinflationary) pressures because
of other factors that are in play at that point in time, then interest rates
are unlikely to move higher (lower). For instance, notice that from late-
2000 to mid-2004, oil prices rose while interest rates in the US fell. The
reason why rising oil prices did not cause interest rates to move higher
during this periodwas because it did not have much impact on inflation.
Also, during this period, the US was battling the dot com bubble crisis and
recession, both of which nullified the impact of rising crude oil prices and
pushed US interest rates lower. As such, keep in mind that commodities
influence the trajectory of interest rates only when movements in
commodities are strongly influencing the trends in inflation. Also, if there
are other bigger factors that are at play, then commodity prices may not
have much of an impact on the trajectory of interest rates.

Correlation between bond yields and interest rates

In the previous chapter, we said that bond yields and interest rates are directly
correlated. That is, rising interest rates cause bond yields to go up, while falling interest
rates cause bond yields to soften. That said, keep in mind that markets are
forward looking. Often, central banks around the world give indications
about the stance of their future monetary policy well ahead of time. As
such, bond yields tend to anticipate changes in interest rates well ahead
of time. If markets anticipate interest rates to rise in future, bond yields will start
rising well ahead of time. Similarly, if markets anticipate interest rates to fall in future,
bond yields will start falling on such expectations.

The above chart compares the Fed Funds rate (blue line) with the 2-year
US Treasury yield (red line) over the past one decade. Notice above that
markets started pricing in the likelihood of higher interest rates well
ahead of time. In fact, see that the first rate hike following the 2008
global financial crisis occurred in December 2015, whereas the 2-year
yield started rising from January 2014 in anticipation of higher interest
rates. Similarly, observe that markets started pricing in the likelihood of
lower interest rates from January 2019, whereas the first rate cut by the
Fed occurred only 6 months later.

The above chart compares the Fed Funds rate (red line) with the 2-year
US Treasury yield (green line) and the 10-year US Treasury yield (blue
line) over the past one decade.An important thing to keep in mind is that
short-term yields are more sensitive to interest rates than are long-term
yields, which are more sensitive to long-term inflation expectations. For
instance, notice in the chart above that the 2-year yield started pricing in
the likelihood of interest rate increases in the US almost 2 years ahead of
the first rate hike by the Fed in December 2015. On the other hand, see
that the 10-year yield continued declining during this period and
bottomed out almost 6 months after the first rate hike. Subdued long-
term inflationary expectations amid declining commodity prices and a
slowing global economy was one of the main reasons why the 10-year
yield diverged from its 2-year counterpart back then. That said, notice
that the two essentially topped out at the same time in January 2019,
before heading lower. From this, we can conclude that:

Short-term yields are extremely sensitive to interest rate changes/expectations

of interest rate changes. They tend to rise ahead of actual rate hikes by the
central banks, and vice versa

Long-term yields are very sensitive to long-term inflation expectations as well. At

times when long-term inflation is expected to rise, so would yields of longer-term
bonds in order to compensate for higher inflation in the future, and vice versa

Short-term interest rates in an economy are influenced by the central bank of

that economy

Long-term interest rates in an economy are influenced by demand for and the
supply of long-term bonds. The higher the demand, the lower the yield tends to
be, and vice versa.

As a result, always get into the habit of looking at both, short-term yields,
which tell a lot about interest rate expectations, and long-term yields,
which tell a lot about long-term inflation expectations.

Correlation between commodities and bond yields

So far, we have discussed the following key concepts as far as

commodities are concerned:

If steadily rising commodity pricesfuel inflation, interest rates tend

to rise

If steadily declining commodity prices fuel very low inflation or

deflation, interest rates tend to drop

Besides, we have discussed the following key concepts as far as bond

yields are concerned:

If markets anticipate interest rates to rise in future, bond yields will

start rising (with short-term being more sensitive than long-term)

If markets anticipate interest rates to fall in future, bond yields will

start falling (with short-term being more sensitive than long-term)

From the above, we can conclude the following correlation exists

between commodities and bond yields, in general:

If steadily rising commodity prices fuel inflationary pressures, bond yields tend to
rise

If steadily falling commodity prices fuel dis-inflationary/deflationary pressures,

bond yields tend to drop

Inflation is an important component in the commodity and bond yield

correlation. For instance, if rise in commodity prices are fuelling
inflationary pressures in an economy, bond yields will tend to rise.
However, if risein commodity prices are not fuelling inflationary
pressures, bonds yields are unlikely to rise much.In this section, we shall
talk about the correlation between yields and commodities. Keep in mind
that not all commodities share the same correlation with yields. While
several move in tandem with yields, a few tend to move in the opposite
direction. Hence, it is also important to look at the correlation between
an individual commodity and yields, rather than just looking at the
correlation between an overall commodity index and yields. Let usnow
talk about the correlation between:

Copper and yields

Gold and yields

Crude oil and yields

Correlation between Copper and Yields

Copper is often considered a leading indicator of global economic health,

given its widespread usage across industries as well as in the
construction and the home building sector. Strengthening economic
conditions cause industrial and construction activity to pick up, which
boosts demand for copper and subsequently lifts its price. Usually,
strengthening economic conditions also coincide with rising bond yields,
because as economic conditions strengthen, inflation starts to pick up,
which reduces demand for traditional bonds. Similarly, weakening
economic conditions cause industrial and construction activity to
slowdown, which reduces demand for copper and subsequently drags
down its price. Usually, weakening economic conditions also coincide
with falling bond yields, because as economic conditions deteriorate,
inflation starts to decelerate, which increases demand for traditional
bonds.

The above chart shows the correlation between US copper prices and US
10-year treasury yield since 2004. Notice that the two usually tend to
move in sync. It can be seen above that the multi-year rally in copper
prices until March 2008 (A to B) coincided with a steady rise in bond
yields. Post this, for the next few months (B to C), both copper prices and
yields plunged due to the global financial crisis. Since bottoming out in
December 2008, copper recouped its entire 2008 decline until January
2011 (C to D). During this period, bond yields also rose sharply.
Meanwhile, in the next few years from January 2011 till January 2016 (D
to E), copper prices steadily declined, primarily weighed by a cooling
Chinese economy, which reduced the demand for copper. This decline in
copper prices also coincided with falling bond yields, as long-term
inflationary pressures receded. Following this, from January 2016,
copper prices strengthened over the next two-and-half years (E to F), as
the steady slowdown in Chinese growth started moderating and as the
US presidential election in 2016 boosted thereflation trade. This rebound
in copper prices caused yields to recover during the same period. After
topping out in June 2018, copper prices declined until March 2020 (F to
G), weighed by the resumption of a slowing Chinese economy, trade war
between the US and China, and the onset of the Covid-19 pandemic. This
decline in copper prices coincided with US yields plunging to record lows
as long-term inflationary pressured ebbed and deflationary, recessionary
fears grew. Since March 2020, copper prices have rebounded strongly,
but yields have failed to rebound, as the unprecedented policy measures
of the Federal Reserve have kept yields suppressed near their life-time
lows.

From the above chart, we can see that:

There is a strong positive correlation between copper and yields

Strengthening copper prices exert upward pressure on yields, and vice versa

China has a strong impact on the trajectory of copper prices and subsequently on
US yields

Copper acts as a leading indicator of global economic health because of its

widespread usage

Correlation between Gold and Yields

Gold is often considered a hedge against inflation, tending to perform

well when inflationary pressures are rising and when the rise in nominal
yields is not able to keep up the pace with the rise in inflation. Gold also
performs well during times of rising tail risks and heightened volatility in
the financial markets. Apart from equities, fixed income instruments,
cash, and real estate, gold also forms an important part of an investor’s
portfolio that is used to diversify risks. Here is an important concept to
remember about gold. Gold is a non-interest-bearing asset. In other
words, gold does not generate periodic cash flows like stocks
(dividends),bonds (coupons), and real estate (rent)do. Instead, gold
generates returns by way of capital appreciation only. As such, gold, a
non-interest-bearing asset, always tends to compete with interest-
bearing assets, such as stocks, bonds, and real estate. It is because of this
that gold usually tends to move in the opposite direction of bond yields.
When sovereign bond yields rise, the attractiveness of gold reduces, and
vice versa.
The above chart shows the correlation between gold price and US 10-
year yield since 1999. It can be seen that gold made a major bottom in
September 1999 and entered into a very powerful uptrend that lasted
until August 2011 (A to B). This bull market in gold coincided with a
major decline in US yields. After topping out in August 2011, gold
steadily declined till November 2015, before consolidating (albeit with
forming higher lows) until mid-2018 (B to C). During this period, the US
yields were quite volatile. But by mid-2018, they had managed to more
than double from the mid-2012 lows. Finally, observe that the top in
yields in September 2018 and their subsequent sharp fall since then (C to
D) coincided with gold entering into a major uptrend during this period.
In fact, the plunge in US yields to record lows has coincided with gold
prices recently surging to record highs. Meanwhile, the shaded regions
represent periods when the inverse correlation between gold and yields
broke. See that during this period, the two moved in tandem.
Occasionally, in the short-to-medium-term, the correlation between the
two can break down because of outside market forces, before resuming
again.

Meanwhile, the above chart shows the correlation between gold price
(RHS, red line) and US 10-year TIPS yield (LHS, blue line). Notice how a
major peak in one coincides with a major trough in the other, and vice
versa. Gold tends to thrive when real yields (nominal yields adjusted for
inflation) turn negative. This is because when real yields turn negative,
bonds are effectively not generating any periodic returns, when adjusted
for inflation. This magnifies the demand for gold. On the other hand,
when real yields are positive and are rising, demand for gold tends to
reduce as bonds start becoming more attractive due to the periodic cash
flows that they generate.

From the above discussion, we can conclude that:

Gold tends to perform well when rise in nominal yields fail to keep pace with rise
in inflation

Gold also performs well during periods of risk aversion and heightened volatility

There is a negative correlation between gold price and bond yields

Risingbond yieldsexert downward pressure on gold, and vice versa

Gold and real yields share a strong negative correlation

Gold thrives during periods when real yields and falling and near zero, and vice
versa

Correlation between Crude oil and Yields

Crude oil is a very crucial commodity, given the wide-ranging impact it

has on the lives of everyone. Given its massive usage in the industrial
sector as well as in transportation sector, crude oil directly as well as
indirectly affects inflationary trends. The direct impact of crude oil on
inflation is that it affects fuel price, which in turn affects the disposable
income of people (the higher the fuel prices goes, all else equal, people
will spend a higher portion of their income on fuel, which in turn will
reduce their disposable income, and vice versa). Meanwhile, the indirect
impact of crude oil on inflation is that affects the cost of transporting
goods and products while also raising manufacturing costs, which in turn
affects the selling price of such goods and products (think about fruits
and vegetables, for instance. A surge in transportation costs will increase
the price of these commodities, and vice versa). While rising oil prices
could suggest that global economic conditions are strengthening, too
high a price can pose problems and lead to surge in price pressures. On
the other hand, while falling oil prices are beneficial to consumers,too
low a price can raise worries over the health of the global economy.
Hence, stability in oil price is usually preferred by most nations around
the world.

The above chart shows the correlation between crude oil price and US
10-year yield since 2000. See that oil prices surged nearly five-folds from
late-2001 to mid-2006 (A to B). As the oil price rally gathered
momentum, yields bottomed out in mid-2003 and steadily climbed over
the next three years. Meanwhile, notice the first shaded region. During
this period, oil prices tripled. Despite this, yields softened. The major
reason for the softening of yields was the Fed starting to cut interest
rates from September 2007 amid rising turmoil in the US housing sector.
Similarly, notice the second shaded region. During this period too, oil
prices rose but yields fell. The fall in yields was again because of the
unprecedented accommodative measures the Fed took to prevent the US
economy from collapsing. As a result of such Fed-induced interventions,
between 2007 and 2013, whenever oil prices rose, it did not cause yields
to move higher. Since 2013 however, the traditional positive correlation
between oil prices and yields has resumed. Notice that the plunge in oil
price from mid-2013 to mid-2016 coincided with a fall in yields (C to D).
Meanwhile, the recovery in oil price from mid-2016 to late-2018
coincided with a rise in yields (D to E). Again, the slump in oil price from
late-2018 to March 2020 coincided with a drop in yields to record lows
(E to F). Since March 2020 however, the two have again diverged. While
oil prices have recovered, yields are still suppressed. Again, this
divergence is because of the unprecedented actions the Fedhas taken to
prevent Covid-19 lockdown from hampering the US economy. Due to the
Fed’s actions, yields have continued hovering near record lows.

The above chart shows the correlation between Brent crude (RHS, red
line) and US 10-year breakeven inflation rate (LHS, blue line) since 2004.
The 10-year breakeven inflation rate measures the expected inflation
and is calculated as the 10-year nominal yield minus the 10-year TIPS
yield. Notice above how strongly long-term inflation expectations are
influenced by the price trajectory of crude oil. It can be seen that when oil
prices rise, so do inflation expectations, and vice versa.

From the above discussion, we can conclude that:

Oil prices strongly influence the trajectory of inflation, both directly and
indirectly

There is a positive correlation between oil price and bond yields

Rising oil price causes bond yields to rise, and vice versa

There is a positive correlation between oil price and breakeven inflation rates

Rising oil price causes breakeven inflation rates to rise, and vice versa

Sometimes, because of the actions of the Fed, the positive correlation between oil
and yields could break

Bonds and Stocks Commodities and Stocks

Next 7 Lessons 9 Lessons

Chapter In this chapter, we will explain the

correlation between stocks and
bonds and the role interest rates
play in impacting stock prices. It is
important to understand how the
two correlate to each other and
keep a track of how that
correlation is evolving over time.
Often, change in the direction of
bonds can influence the direction
of stocks as well
In this chapter, we shall study the
fourth most critical intermarket
relationship, which is the one
between Commodities and Stocks.
When comparing the correlation
between the two, we shall talk
about commodities, both from a
collective perspective as well as
from an individual perspective.

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Home : Intermarket Analysis and Sector Rotation

Bonds and Stocks

In this chapter, we will explain the correlation between stocks and bonds and the role interest rates play in impacting stock prices. It is
important to understand how the two correlate to each other and keep a track of how that correlation is evolving over time. Often, change in
the direction of bonds can influence the direction of stocks as well

Abhishek Chinchalkar (18th Aug, 20)

22 minutes read

So far, we have understood the correlation between dollar and

commodities and that between commodities and bonds. In this chapter,
we will explain the correlation between stocks and bonds and the role
interest rates play in impacting stock prices. It is important to understand
how the two correlateto each other and keep a track of how that
correlation is evolving over time.Often, change in the direction of bonds
can influence the direction of stocksas well.

Correlation between interest rates and stocks

Interest rates have a bearing on the price of a stock. Generally, there is an

inverse correlation between the two. As interest rates rise, the cost of
borrowing increases. When the cost of borrowing increases, not only will
companies have to pay higher interest rates when taking on new loans
but will also have to pay higher interest rates on existing loans (assuming
the interest rates were variable). This has the potential to reduce the
quantum of money that companies borrow from banks. Furthermore, if
interest rates increase, borrowing money by way of issuing corporate
bonds or other fixed income instruments will also become expensive, as
investors would seek out for higher coupons because of the increase in
interest rates. As a result, as the cost of borrowing increases, all else
equal, the profitability of a company reduces due to the higher interest
costs, which subsequently hurts the price of the stock. Similarly, as
interest rates decline, the cost of borrowing reduces. And as the cost of
borrowing reduces, all else equal, the profitability of a company would
increase because of lower interest costs, which subsequently would
benefit the price of a stock.

A stock index, such as the Dow Jones Industrial Average or the S&P 500,
is an index that comprises of various stocks from different sectors. As
changes in interest rates have a bearing on stocks in general, changes in
interest rates affect the stock index as well. Generally, just like in case of
an individual stock, there is an inverse correlation between interest rates
and a stock index too.

The above chart is a long-term chart showing the correlation between

the Dow Jones Industrial Average (DJIA) and the Effective Federal Funds
rate, which is the proxy for interest rates in the US. It can be seen that
from mid-1960s to early-1980s, interest rates in the US trended higher
because of high inflation that was prevalent during that period. This
combination of surging interest rates to combat ultra-high inflation
caused the US markets to virtually consolidate within a sideways range
for almost a decade and a half. However, observe that since the early-
1980s, interest rates in the US have been in a secular downtrend. See
that the Federal Funds rate peaked in mid-1981 at over 20% and has
since declined to as low as 0%. This peak in US interest rates in mid-1981
caused the US markets to break out of their 15-year sideways range in
late-1982, before entering into a secular bull market. See that after
exiting the consolidation, the DJIA has rallied manifold times.

Having said that, in the medium-term, the inverse correlation between

interest rates and stock prices may change at times depending upon
factors such as the state of the economy, the level of inflation, the
positioning of the economy within the business cycle etc. For instance,
during times wheninflationary pressures are slowly rising and economic
conditions are strengthening, interest rates and stock prices may rise in
tandem for some period of time as long as rising interest rates do not
start exerting downward pressure on the demand for a company’s goods
and services. Until then, the higher debt expenses that a company incurs
due to rising interest rates can be more than offset by the higher
revenues that it generates from the sales of such goods and services,
thereby helping the stock price to continue risingdespite the rising
borrowing costs.Similarly, during times when deflationary pressures are
mounting or an economy is experiencing a sharp slump, interest rates
and stock prices may fall in tandem as long as falling interest rates do not
start to stimulate the demand for a company’s goods and services. Until
that happens, the reducing debt burden of a company due to lower
interest rates is unlikely to offset the lower revenues that a company
generates from the sale of goods and services, thereby pressurizing the
stock price to continue falling despite the declining interest rates. We
will talk more about the business cycle in a later chapter.

The above chart compares the price action of DJIA and the Effective Fed
Funds rate over the past one decade. Notice the shaded region in the
DJIA panel. There was increased volatility in stock prices during this
time, which was partly due to the fact that interest rates in the US were
to start rising soon, after almost 8 years of zero rates. Such worries
increased the turbulence in the US as well as in the global markets.
However, by then, the US economy was strengthening. The series of rate
increases by the Fed and the subsequent higher borrowing costs were
more than offset by strong economic growth and rising demand, causing
stock prices to rise in tandem with interest rate increases between late-
2016 and late-2018.

The above chart compares the price action of DJIA and the Effective Fed
Funds rate between 1999 and 2010. Notice the first shaded box. This
highlights the period between late-2000 and mid-2003. See that during
this period, interest rates and the DJIA both trended lower asthe steep
reduction in interest rates failed to offset the plunge in demand as
economic conditions deteriorated notably. Similarly, observe the second
shaded box. This reflects the period between mid-2007 and early-2009.
During this period too, interest rates and the DJIA both fell sharply as
lower borrowing costs failed to offset the impact of the worst recession
in America’s history since the Great Depression of 1929.

From the above, we can conclude that:

From a secular/long-term perspective, there is an inverse correlation between

interest rates and stocks

As interest rates rise, all else equal, the profitability of a company reduces due to
higher interest costs, which subsequently hurts the price of the stock

As interest rates fall, all else equal, the profitability of a company increases due to
lower interest costs, which subsequently lifts the price of the stock

From medium-term perspective however, there could be periods when interest

rates and stocks move in tandem depending on factors such as the state of the
economy, the level of inflation, the positioning of the economy within the business
cycle etc.

For instance, during periods when inflation is rising slowly and economic
conditions are strengthening, interest rates and stock prices could rise in tandem
as demand tends to more than offset the negative impact of higher borrowing
costs

Similarly, during periods when deflationary pressures are mounting or an

economy is experiencing a sharp slump, interest rates and stock prices can fall in
tandem as the positive impact of lower borrowing costsfails to fully offset the
plunge in demand

Correlation between bond yields and stocks

As we saw in the previous section, the correlation between interest rates

and stocks is not fixed all the time. From a long-term perspective, interest
rates and stock prices typically tend to move in the opposite direction.
However, from a short-to-medium-term perspective, the two can move
in the same direction, especially when economic conditions are
strengthening or deteriorating at a rapid pace. Because bond yields move
in sync with interest rates (with short-term yields being more sensitive to
interest rates than long-term yields), it follows that the correlation
between bond yields and stocks is also not a fixed one.

Generally speaking, from a long-term perspective, bond yields and stock

prices tend to move in the opposite direction. That is, falling bond yields
is bullishfor stocks, while rising bond yields is bearish for stocks. Again,
the reason why this happens is because rising yields coincide with rising
interest rates, and vice versa. However, over the short-to-medium term,
the two can move in sync with each other. Earlier, we spoke that the
traditional inverse correlation between bond yields and stocks could
change depending on the positioning of the economy within the business
cycle. Let us talk about this in moredetail using the case of a business
cycle.

The above chart shows the typical business cycle and the typical
performance of each asset class within this business cycle. This business
cycle theory was promulgated by Martin Pring, a globally renowned
expert on charting and the author of several well-known books on
Technical Analysis. We will speak more about the business cycle in a later
chapter. But for now, keep in mind that, typically, bonds change direction
ahead of stocks, which in turn change direction ahead of commodities.
This applies during both stages of an economic cycle – expansionary and
contractionary stage.

When an economy is somewhere in the earlyexpansionary stage, bonds

tend to peak outand start declining as credit conditions start to tighten.
At this stage, as bonds peak out and start declining, bond yields bottom
out and start rising tojoin in the up move in stocks, which are usually in an
uptrend during this stage because of strengthening economic conditions.
Until somewhere between the mid-to-late-expansionary stage, bond
yields and stocks tend to rise in tandem before higher yields and slowing
economic conditions eventually cause stocks to top out, who then join in
the decline in bond prices.Another way of looking at why bond yields and
stocksrise in tandem between the mid-to-late-expansionary stage is
because bondsand stocks compete for allocation of fundsin an investor’s
portfolio.As the economy is at its strongest point during this stage,
investors allocate a greater proportion of their funds to riskier assets in
search for higher returns, causing stocks to outperform and bonds to
underperform. Similarly, when an economy is in the earlycontractionary
stage, bonds tend to bottom out and start rising as central banks start
cutting interest rates to revive the economy. At this stage, as bonds
bottom out and start rising, bond yields start declining to join in the down
move in stocks, which are usually in a downtrend during this stage
because of deteriorating economic conditions. Until the mid-to-late-
contractionary stage, bond yields and stocks tend to fall in tandem
before lower yields and expectations from far-sighted investorsof an
economic trough eventually cause stocks to bottom out, who then join in
the rally in bond prices.It is for this reason - the positioning of the
economy within the business cycle - that bond yields and stocks tend to
move in tandem in the short-to-medium term.

The above is the long-term chart of the DJIA and the 10y US yield.
During this period, observe that the 10y yield has been in a secular
downtrend, while the US market has been in a secular uptrend. The
steady decline in interest rates over the last four decades has played
animportant role in the stock market rally.

From the above, we can conclude that:

From a secular/long-term perspective, there is an inverse correlation between

bond yields and stocks

As bond yieldstrend lower, all else equal, stock prices trend higher, and vice versa

From short-term to medium-term perspective however, there could be periods

when bond yields and stocks move in tandem

One reason for this is the positioning of the economy within the business cycle

Between the early-expansionary and the mid-to-late-expansionary stage of a

business cycle, yields and stocks both rally due to robust economic conditions

Between the early-contractionary and the mid-to-late-contractionary stage of a

business cycle, yields and stocks both fall due to deteriorating economic
conditions

In 1998, the traditional correlation between yields and stocks

decoupled

In 1998, an important thing happened: the traditional inverse correlation

between bond yields and stocks that had prevailed for the past several
years broke. One reason for this was the Asian financial crisis. This
turmoil in Asia and other regions increased appetite for the safe haven
US treasuries, causing yields on these instruments to fall. At the same
time, as the crisis began spreading to regions outside of Asia, demand for
riskier assetsdiminished towards the turn of the century,causing stocks
to top out and start declining. Let us look at a few charts to understand
this better.

The above chart compares the DJIA with the US 10y yield between 1996
and 2012. Notice the 13 year period between the black vertical lines.
During this period, the traditional inverse correlation between bonds
yields and stocks decoupled and the two moved in tandem. That is, they
both rose and fell together most of the times.

If you closely observe, you will see that during both the 2000 dot com
bubble and the 2007-08global financial crisis, bond yields broke
lowerfirst,and stocks followed suit later (see the corresponding purple
trend line). Given the positive correlation that had existed between bond
yields and stocks since late-1998, the trendline breakdown in the 10y
yield in March 2000 coupled with a slowing US economy was a warning
that the rally in stocks could be running into trouble. Such warning did
materialize five months later in September 2000 when the DJIA broke
below the trendline. The two then fell in tandem over the next two years.
However, an interesting thing to note is that the DJIA bottomed in
September 2002, whereas bond yields did not bottom until June 2003.
This delayed bottoming in bonds yields after stocks had already
bottomed was primarily due to interest rates in the US, which continued
declining until mid-2003. See here that the steady decline in US yields
between January 2000 to June 2003, which reflected lower interest
rates in the US, eventually ended the downtrend in stocks and ushered in
a new wave of up move over the next five years.

Meanwhile, notice that the four year up move in 10y yield ended when it
broke below the rising trendline in August 2007. While the DJIA made a
life-time high during this period, the breakdown in bond yields coupled
with the positive correlation that had existed between bond yields and
stocks since late-1998 yet again warned that the rally in DJIA could run
into trouble. This is what happened in January 2008 when the DJIA also
broke below its rising trendline support, thereby ending a 5-year bull
market in stocks. For the remainder of 2008, both bond yields and stocks
fell together sharply amidst the global economic turmoil. Eventually
however, the steep fall in US interest rates and bond yields caused stocks
to bottom out in March 2009, roughly three months after yields had
bottomed out in December 2008. Note here that the 10y yield bottomed
out prior to the bottom in stocks. The positive correlation between bond
yields and stocks continued for the next couple of years. However, this
positive correlation had weakened noticeably during this two year
period, as stocks recovered strongly from March 2009 lows but bond
yields struggled to gain much ground on the upside as the Quantitative
Easing program launched by the Fed supressed interest rates and bond
yields.

Since the last decade, the correlation between yields and stocks
has varied

From 2011, the correlation between bond yields and stocks has varied.
The US markets bottomed out in early-2009 and entered into a strong
bull market over the next one decade. During this 10+ year bull market in
stocks, rallies were quite powerful and long-lasting while corrections
were quite shallow and only for brief periods. On the other hand, yields
mostly trended lower during this period, but their movements have been
quite volatile.

The above chart compares the DJIA with the US 10y yield since 2010.
Within this chart, notice the 7 year period between the black vertical
lines. During this period, US markets steadily headed higher, while the
10y yield fluctuated within a wide range of 1.5-3.5% without a clear
direction.

Within this 7 year period, notice the two red boxes in the 10y yield panel
and the corresponding boxes in the DJIA panel. This represents the
intermediate up moves in the 10y yield. It can be seen that the
intermediate up moves in bond yields during this period were
accompanied by strong advances in stocks, as represented by the DJIA
index.On the other hand, within this 7 year period, notice the non-shaded
regions in the 10y yield panel and the corresponding non-shaded regions
in the DJIA panel. This represents the intermediate down moves in the
10y yield. It can be seen that the intermediate down moves in bond yields
during this period were accompanied by sideways to only modest rallies
in stocks. This suggests that between early-2011 and late-2018, the
correlation between bond yields and stocks varied, in a way that rising
bond yields benefited stocks while falling bond yields did not have much
of an impact on stocks.

Meanwhile, since late-2018, observe that the 10y yield has plunged from
over 3.25% to a record low of under 0.5%. During this period, stocks have
essentially traded in a pretty volatile and wide range. However, while the
swings in stocks have been pretty wild, it can be seen that, net-net, stocks
today are essentially where they were in late-2018. In other words, the
correlation that has prevailed since early-2011 still continues till date,
wherein rising bond yields tend to underpin stocks, while falling bond
yields do not have much of an overall impact on stocks.

From the above, we can conclude the following about the prevailing
correlation between bond yields and stocks:

Since 1998, the traditional inverse correlation between bonds yields and stocks
has decoupled and the two have sinceusually moved in tandem

Bond yields can often act as a leading indicator for stocks

During both the dot com bubble of 2000 and global financial crisis of 2007-08,
bond yields broke down first and stocks followed suit a few months later

Since 2011, the correlation between bond yields and stocks has varied in a way
that rising bond yields have benefited stocks but falling bond yields haven’t had
much of an impact on stocks. In fact, during periods when yields have declined,
volatility in stock markets has shot up

Since late-2018, yields have plunged to record lows, but stocks today are
essentially where they were back in late-2018, albeit with a great degree of
volatility

At the time of writing, bond yields and stocks are correlated in such a way that
stocks tend to react quite positively to rising bond yields, but they tend to react in
a volatile manner to falling bond yields

Keep in mind that unlike the correlation between the dollar and commodities or
that between commodities and bond yields, the correlation between bond yields
and stocks can vary

At times, the two could be positively correlated; while at other times, the two
could be negatively correlated

It is because of this that one needs to keep a close track of the correlation
between bonds yields and stocks from time to time

Yield curve inversion and its impact on stocks

A yield curve is a graphical representation of bond yields having a similar

underlying instrument but differing maturities. As an example, the
current yield of various US treasury securities ranging from short-term
to medium-term and long-term would be plotted on a graph and then
connected using a curve to get a visual representation of yields across
various maturities. The shape of the yield curve gives vital economic
information such as the state of the economy and the direction in which
it is headed, investors’ perception about risk, the direction in which
interest rates could move etc.As such, by tracking the shape of the yield
curve periodically, a trader/investor will be in a better position to
understand the state of the economy and accordingly deploy or modify
trading/investment strategies.

There are four types of yield curve: normal, steep, flat, and inverted.

Normal yield curve

A normal yield curve is one in which long-term yields are aboveshort-

term yields. It is called normal because, most of the times,long-term rates
are aboveshort-term rates to compensate the holder for taking duration
and credit risk. When plotted using a curve, a normal yield curve will
slope upwards to the right.A normal yield curve usually occurs when economic
conditions are either strengthening or are reviving following a period of slowdown.

Steep yield curve

A steep yield curve is one in which long-term yields are rising at a faster
rate than short-term yields. When plotted using a curve, a steep yield
curve will look similar to a normal yield curve but with a difference that it
will slope upwards at a steeper angle. A steep yield curve usually occurs when
economic conditions are either strengthening or are reviving following a period of
slowdown.

Flat yield curve

A flat yield curve is one in which long-term yields and short-term yields
are essentially identical. When plotted using a curve, a flat yield curve is
one which will neither trend up nor down but will essentially be flat. A flat
yield curve is usually associated with an economy that is either slowing and slipping
towards a recession or reviving and emerging out of a recession.

Inverted yield curve

An inverted yield curve is one in which long-term yields are below short-
term yields. It is called inverted because this situation, wherein short-
term instruments are yielding more than long-term instruments, is not
normal and occurs quite infrequently. When plotted using a curve, an
inverted yield curve will slope downwards to the right. An inverted yield
curve usually occurs when economic conditions are rapidly deteriorating. Historically,
an inverted yield curve has been a reliable indicator of future recession.
The chart above shows the shape of the current US treasury yield curve,
which is the most widely tracked yield curve in the world. The yields
across various US treasury instruments can be found on this link of the US
Treasury Department.Notice that the shape of the yield curve is mostly
normal, except for a couple of inversions in between (2y yield is below 1y
yield and 3y yield is below 2yyield). From the chart, it can also be
observed that the long-end of the yield curve is steep. The current yield
curve, as at the time of writing, is reflective of improving risk sentiment
and economic conditions. That said, keep in mind that as yields change,
the shape of the yield curve can also change. Hence, it is necessary to
keep a periodic track of the yield curve to gauge what market
participants, via the bond markets, are anticipating about future
economic conditions and interest rates.

Besides tracking the current shape of the overall yield curve, one could
also track the historical spread between two differing yields. Of all the
maturities discussed above, one of the most widely tracked yield spread
is that of the 10 year and the 2 year treasury note.

The chart above compares the spread between the 10-year and the 2-
year treasury yield with the DJIA. A red horizontal line has been drawn
on the top panel to show equilibrium. When the spread is above the red
line, it means the curve is normal as the 10y yield is above the 2y yield.
On the other hand, when the spread is below the red line, it means the
curve is inverted as the 10y yield is below the 2y yield. See that most of
the time, this spread is normal. However, sometimes, it tends to invert. As
we said earlier, an inverted curve occurs when economic conditions are
rapidly deteriorating, causing long-term yields to fall below short-term
yields.

In the chart above, observe the shaded boxes in the top panel with the
corresponding boxes in the bottom panel. This reflects periods when the
10y2y spread inverted and shows the corresponding behaviour of stock
markets during this period of yield curve inversion. See that whenever
the 10y2y yield curve has inverted, it has eventually spelled trouble for
the stock markets. Also observe in the chart each red arrow in the top
panel and the corresponding red arrow in the bottom panel. The arrow in
the top panel reflects the period when the yield curve first inverted,
whereas the corresponding arrow in the bottom panel reflects the period
when the stock market topped out and started declining. It can be seen
that, since the late-1980s, there has been a gap between the time the
10y2y spread first inverted and the time the stock market topped out.
While the chart shows that every 10y2y yield curve inversion since the
late-1980s has spelled trouble for the stock market, it must also be kept
in mind that there has been a notable delay between the time the yield
curve inverts and the time stock markets actually top out. As such, a yield
curve inversion doesn’t outrightly mean a trader/investor must start
reducing equity exposure right away, but just that it is time to become
cautious and be aware of the possibility that the stock market could
come under pressurein the months ahead. The table below shows the
lead-lag between the first time the 10y2y yield spread inverted and the
time the stock market actually topped out:

First Yield Curve

DJIA peak Lag (in months)
Inversion
December 1988 July 1990 19
March 1998 January 2000 22
January 2006 October 2007 21
August 2019 February 2020 6

The chart above shows the spread between the 10y2y yield curve.
Meanwhile, the grey shaded regions reflect periods when the US
economy experienced recession. It can be seen that since the 1980s,
every recession in the US was preceded by this 10y2y yield curve
inverting, including the most recent one, in which the yield curve briefly
dipped below zero in August 2019 before normalizing.

Other than the most popular 10y2y spread, the 10y3m spread is also
quite popular and is regularly tracked by market participants. The 10y3m
spread measures the yield spread between the 10-year treasury note
and the short-term 3-month treasury bill.

From the above, we can conclude that:

The shape of the yield curve, either overall or selective, tells a lot about the state
of the economy and the direction in which it is headed as well as about investors’
perception of risk

An inverted yield curve occurs quite infrequently. However, whenever it occurs, it

spells trouble ahead for the economy as well as for the stock market

The 10y2y US treasury yield spread is the most widely tracked yield spread in the
world

Every recession in the US since the 1980s has been preceded by the 10y2y yield
curve inverting

There is a notable lag between the time the 10y2y yield curve first inverts and the
time the stock market peaks out and starts declining

Besides the 10y2y spread, the 10y3m US yield spread is also monitored closely

Given the importance of yield curve, one must closely monitor it periodically

An inverted yield curve does not guarantee a recession, but rather only increases
the probability of one occurring in the months ahead

Commodities and Stocks Other Correlations

Next 9 Lessons 6 Lessons

Chapter In this chapter, we shall study the

fourth most critical intermarket
relationship, which is the one
between Commodities and Stocks.
When comparing the correlation
between the two, we shall talk
about commodities, both from a
collective perspective as well as
from an individual perspective.
In this chapter, we shall study the
two remaining intermarket
correlations, which can add a lot of
value when tracked periodically
while also provide clues on the
overall risk appetite of market
participants. The remaining two
correlations that we will be
covering in this chapter include the
correlation between:

* Currencies and Bonds

* Currencies and Stocks

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Home : Intermarket Analysis and Sector Rotation

Commodities and Stocks

In this chapter, we shall study the fourth most critical intermarket relationship, which is the one between Commodities and Stocks. When
comparing the correlation between the two, we shall talk about commodities, both from a collective perspective as well as from an individual
perspective.

Abhishek Chinchalkar (24th Aug, 20)

17 minutes read

So far, we have discussed three of the four most critical intermarket

relationships. These are the relationships between:

Currencies and Commodities

Commodities and Bonds

Bonds and Stocks

In this chapter, we shall study the fourth most critical intermarket

relationship, which isthe one between Commodities and Stocks. When
comparing the correlation between the two, we shall talk about
commodities, both from a collective perspective (CRB index) as well as
from an individual perspective (Gold).

Commodities and stocks tend to move in tandem

Generally, commodities and stocks move in sync.In an economy that is

expanding, demand for goods and services will be on the rise. This
increase in demand for goods and services from consumers will increase
the demand for raw materials, such as commodities, that are needed to
make such products. So, as the demand for goods and services goes up, so
does the demand for commodities. Hence, when economic conditions are
strengthening, commodities and stocks tend to rise in tandem. However,
once the inflationary impact of rising commodity prices becomes a threat
and prompts central banks to adopt tight monetary policies, commodities
and stocks tend to decouple. This is because as interest rates start going
up, the cost of borrowing also increases while the quantum of money
supply in the economy decreases. This starts dampening the demand for
a company’s goods and services, causing stock prices to start declining.
Eventually, as the demand for goods and services reduces, so does the
demand for raw materials, which cause commodities to top out and start
following stocks lower.

Similarly, in an economy that is contracting, demand for goods and

services will reduce. This reduced demand for goods and services will
reduce the demand for commodities too. Hence, when economic
conditions are deteriorating, commodities and stocks tend to fall in
tandem. To combat the threat of recession and/or deflation, central
banks start adoptingaccommodative monetary policies, causing
commodities and stocks to start decoupling. The increased money supply
eventually starts to revive the demand for a company’s goods and
services, causing stock prices to start bottoming out and recover from
their troughs. Eventually, as the demand for goods and services revives,
so does the demand for raw materials, which causes commodities to
bottom out and start following stocks higher.

This typical behaviour is identical with what we said in the previous

chapter. Recollect from the business cycle image that by the time the
economy enters the late-expansionary stage, stocks would typically have
topped out and started declining, while commodities would still be in an
uptrend but nearing the end of it. During this period between the
economy topping out and entering the late-expansionary phase, it is
typical for stocks and commodities to diverge beforecommodities join
stocks lower as the economic growth continues decelerating. The same
logic also applies, but of course in reverse order by the time the economy
enters the late-contractionary stage. By then, stocks would typically have
bottomed out and started rising, while commodities would still be in a
downtrend but nearing the end of that downtrend. During this period
between the economy bottoming out and entering the late-
contractionary phase, it is typical for stocks and commodities to diverge
before commodities join stocks higher as the economy continues
reviving.

From this, it can be gleaned that:

Stocks and commodities move in sync most of the times

In a reviving/strengthening economy (i.e. between the late-contractionary stage

till the time the economy peaks out), stocks and commodities tend to rise most of
the time (with intermittent corrections in between)

In a weakening/contracting economy (i.e. between the late-expansionary stage till

the time the economy bottoms out), stocks and commodities tend to fall most of
the time (with intermittent recoveries in between)

Between the time the economy peaks out and enters the late-expansionary stage,
stocks and commodities tend to decouple, with stocks starting to declinewhile
commodities continue to rally, before eventually topping out and joining stocks
lower

Between the time the economy bottoms out and enters the late-contractionary
stage, stocks and commodities tend to decouple, with stocks starting to rally
while commodities continueto fall, before eventually bottoming out and joining
stocks higher

The traditional correlation held well between 1994 and 2011

The chart below compares the price action between the Thomson
Reuters CRB Index and the Dow Jones Industrial Average (DJIA) index
between mid-1994 and late-2011.

Broadly speaking, it can be seen that between this period, the traditional
positive correlation between commodities and stocks held up pretty well.
That is, both the asset classes moved pretty much in tandem during this
period, both during advances as well as during declines. Notice the
arrows in the CRB Index and the corresponding arrows in the DJIA index.

See that the DJIA index made a major top in December 1999, while the
CRB index topped out almost a year later in November 2000. Between
December 1999 and November 2000, the two decoupled as stocks fell
while commodities rose. This adheres to what we said earlier that stocks
tend to top out and start declining before commodities top out and start
declining. What is however interesting to note is that the CRB index
bottomed out in January 2002while the DJIA index followed suit later in
September 2002. One of the reasons why commodities bottomed out
ahead of stocks was the action taking place in the currency market. The
bottom in the CRB index in January 2002 coincided with a major top in
the DXY index in January 2002 as well. As the dollar started its
precipitous fall, commodities received a major boost, causing them to
bottom out before stocks and start rallying.

Meanwhile, after bottoming out in September 2002, the DJIA joined the
up move in the CRB index and both the indices entered a powerful
uptrend over the next 5-6 years. The DJIA index eventually topped out in
October 2007 and started declining, while the CRB index topped out
nearly 9 months later in June 2008. Between October 2007 and June
2008, stocks fell while commodities entered a parabolic rally before
eventually topping out. From June 2008 to February 2009, both stocks
and commodities came under immense selling pressure because of a
recession and the global financial turmoil. Both the CRB index and the
DJIA index bottomed out simultaneously in February 2009, boosted by
massive amounts of liquidity and economic stimulus poured in by central
banks around the world to curtail the financial crisis. Over the next
couple of years from February 2009, both commodities and stocks again
rallied in tandem.

This 16-year period between 1994 and 2011 was characterized by

commodities and stocks moving pretty much in tandem with each other,
both during rallies as well as during declines. However, post 2011 the
traditional positive correlation between the two decoupled.

This traditional correlation then decoupled between 2011 to

2019

As we saw above, the first decade of the 21st century was characterized
by commodities and stocks moving in tandem. However, the second
decade of the 21st century was characterized by the traditional positive
correlation between commodities and stocks decoupling. Again, the
chart below compares the price action between the CRB Index and the
DJIA index between 2008 till date.

Notice the region within the two horizontal lines. This reflects the period
between 2011 and 2019. See that during this period, the CRB index fell
until January 2016 before consolidating over the next four years,
whereas the DJIA index steadily headed higher. In fact, during this entire
period, the CRB index nearly halved in value, while the DJIA index nearly
tripled in value.

Commodities weaken due to Dollar strength, China slowdown

The two major factors that contributed to the bull market in commodities
between 2002 and 2008 were dollar weakness and economic boom in
China. These factors combined bolstered the demand for commodities, in
turn causing them to soar during this period. This role, however,reversed
between 2011 and 2019. During this period, the dollar strengthened
while China entered a prolonged period of economic weakness. These
factors reduced the demand for commodities, in turn causing them to
weaken.

The chart above shows the annualized YoY percent change in China’s
GDP. See how the growth rate of the world’s largest commodity
consumer accelerated from 2000 to 2008, before gradually decelerating,
especially since 2011. This has had a notable impact on commodities
prices. Being the second largest economy in the world as well as the
largest commodity consumer, it makes sense to keep a periodic track of
China’s health as this tends to strongly influence trends in commodities.

Meanwhile, the chart above compares the CRB index with the DXY index.
See that the decline in commodities between 2011 and 2019 more or
less coincided with a rising dollar during this 8 year period.

Stocks strengthen due to ultra-low interest rates, liquidity

infusion

On the other hand, stocks decoupled from commodities between 2011

and 2019 and instead rallied on the back of near-zero interest rates not
only in the US but across several other major developed economies as
well. The near-zero interest rates coupled with abundance of liquidity
infused by global central banks during and after the 2008 turmoil played
a key role in driving stock prices higher.

See in the above chart that the decline in Fed Funds rate from 6.50% in
late-2000 to 1.00% by mid-2004 played an important role in ending the
bear market and ushering a new 5-year bull marketin US stocks. Similarly,
the Fed Funds rates declined from 5.25% in mid-2007 to 0% by early-
2009 and then stayed there until late-2015. Also, the Fed printed billions
of dollars and infused it into the economy between 2008 and 2012. Such
unprecedented measures by the US central bank bolstered liquidity into
the economy, which eventually found its way into equities in search for
higher returns. This has been a major driver behind the stock market
advance from the March 2009 bottom. Just to say, the DJIA index nearly
quadrupled in value from March 2009 till end-2019.Because of these
contrasting forces, commodities and stocks decoupled for most parts of
the last decade, wherein the former steadily headed lower and the latter
steadily headed higher.

Since the start of 2020, the traditional correlation seems to have

resumed

As stated earlier, the first decade of the 21st century was characterized
by commodities and stocks moving in tandem. Then, the second decade
of the 21st century was characterized by the traditional positive
correlation between commodities and stocks decoupling. Now, since the
start of the third decade of the 21st century (that is since the start of
2020), the traditional correlation between commodities and stocks seems
to have resumed. Notice the usage of the word ‘seems’ here. The reason
for saying so is because we are talking about long-term correlations, ones
that have lasted for 10 years or more. As such, it is still premature to say
the traditional correlation between the twohas resumed because of two
things. One is that this correlation has been in place for just under six
months. There is a need to see whether this positive correlationholds
over a slightly larger time frame, say over one to two years. Second is that
the resumption of the traditional correlation between the two has
occurred in the midst of a major global pandemic and the subsequent
unprecedented measures announced by central banks around the world
to revive the global economy from a deep recession. It is common for
commodities and stocks to move in tandem during and after an economic
crisis. Hence, one must monitor whether the currentpositive correlation
between the two holdsas and when things start normalizing going
forward.

The chart above compares the price action of the CRB Index with the
DJIA index over the last few months. It can be seen that commodities
peaked out and started declining from early-2020. Stocks followed suit
more than a month later and joined commodities in moving lower. From
mid-February, both commodities and stocks fell sharply. Stocks
bottomed out in late-March, while commodities bottomed out a month
later. Since late-April, the two have risen in tandem. So, as we can see
from the chart, the positive correlation between commodities and stocks
has prevailed since mid-February.

From the above, we can conclude that:

Dollar has a strong bearing on the long-term and short-term trajectory of

commodities

Low interest rates and liquidity have a strong positive influence on the trajectory
of stocks

From 1994 to 2011, the traditional correlation between commodities and stocks
held strongly

Between 2011 and 2019, commodities and stocks moved in the opposite
direction, with commodities falling due to strengthening dollar & weakening
Chinese economy and equities rising due to ultra-low interest rates

Since early-2020, the traditional correlation between commodities and stocks

seems to have resumed

However, it is still premature to say whether this traditional correlation has

returned from a long-term perspective

For a year or two, one needs to monitor this correlation to see whether it remains
positive, especially once the current turmoil ends and things start normalizing

Gold as an asset class vs.equities

Gold often forms an important component of an investor’s portfolio.

Usually, it is allocated in a certain proportion in one’s portfolio. This
proportion varies, depending on various factors, the key amongst which
is an investor’s perception about future economic conditions. For
instance, during times when an investor is optimistic about future
economic conditions, he/she tends to allocate a greater proportion to
riskier assets, such as equities. On the other hand, during times when an
investor is pessimistic about future economic conditions, he/she tends to
increase allocation to gold. There are various reasons why gold, rather
than any other commodity, forms an important component of one’s
portfolio. To name a few:

Gold is an extremely liquid asset

Gold is a scarce asset

Gold tends to perform well during both inflationary and

deflationary environment

Gold tends to perform well during times of heightened volatility and

financial turmoil

Gold, being a hard asset, is not subject to default or credit risk

Gold benefits from currency devaluations

The chart above shows the annualized percent return gold has generated
in INR terms since the year 2000. It can be seen that out of 21 years, gold
has generated positive returns on 18 occasions, with an average annual
return of 14% during this period. Taking about gold in USD terms, in the
last 21 years, the yellow metal has generated positive returns on 17
occasions, with an average annual return of 11% during this period.
Meanwhile, let us now compare this to equities. Since 2000, SENSEX has
generated positive returns on 15 occasions, with an average annual
return of 15% during this period. Talking about the US markets, the DJIA
has generated positive returns on 13 occasions, with an average annual
return of 5% during this period. Let us highlight this in table below:

Number of timesGoldhas
Average Annual Return
appreciated annually since 2000
since 2000 (in %)
(in Years)
Gold (in $
17 11.0%
terms)
DJIA 13 5.4%
Gold (in ₹
18 14.1%
terms)
SENSEX 15 14.8%

From the above table, it can be seen that gold in INR terms has
performed nearly as good as Indian markets, in general, have over the
last 2 decades. In USD terms, on the other hand, gold has outperformed
the US markets, in general, during this period.

The correlation between Gold and Stocks

Long-term correlation (Secular trend)

Gold and stocks share a rather dynamic correlation. Typically,if talked

about from a longer-term perspective, it can be said that the yellow
metal and equities move counter to each other. That is, gold tends to rally
during periods when stocks, in general, are declining or are undergoing a
prolonged period of negligible returns. Similarly, gold tends to decline
during periods when stocks, in general, are in a powerful uptrend. To
understand this better, let us compare the price action of gold and the
DJIA over the past four decades.

In the above chart, each arrow in gold and the corresponding arrow in the
DJIA index represents the secular trend (i.e. the long-term trend). We
have split these 40 years into three periods as follows:

The first is from early-1980 to late-1999, represented using the black

arrows. Notice that during these two decades, the DJIA index was in a
very powerful bull market, gaining nearly 15 times in value. On the other
hand, see that gold was in a steady downtrend during these two decades,
losing nearly two-thirds of its value. Observe that the top in the DJIA
index more or less coincided with the bottom in gold towards the end of
1999.

The second is from early-2000 to mid-2011, represented using the green

arrows. Notice that by the end of this period, the DJIA index was
essentially where it was towards the start of this period. In other words,
stocks, in general, languished during this onedecade period. On the other
hand, observe that during this same period, gold entered a major bull
market, gaining almost 8 times in value.

The third is from late-2011 to present, represented using the purple

arrows. During this one decade, it can be seen that the DJIA was in a
steady and powerful uptrend, during which it nearly tripled in value.
Over the same period, see that, as of today, gold is essentially where it
was towards the start of this period. In other words, gold has languished
during the past decade.

Medium-term correlation (Primary trend)

While in the long-term (10 years or more), gold and stocks usually move
counter to each other, in the medium-term (4-5 years), the correlation is
not so straight forward. Sometimes, the two move in the opposite
direction, while on other occasions they move in the same direction. To
understand this better, let us compare the two between 2003 and 2011
and then again between 2011 and 2020. The chart below compares the
price action of the DJIA index and gold between 2003 and 2011:

Notice above that between March2003 and October2007, both gold and
the DJIA rallied. Later between March2008 and November2008, the two
fell. Then again, between March2009 and August2011, the two moved
higher. In the long-term chart shown earlier, we saw that between early-
2000 and mid-2011, gold was in a powerful uptrend, while the DJIA
index was essentially unchanged. However, when dissected from a
medium-term perspective, three primary trends are clearly visible in the
DJIA index within the context of the larger secular trend– first up (2003-
07), then down (2008), and then up again (2009-11). And during this
period, as said above, even gold moved in tandem with the stock markets.

Why does this happen? The reason why this happens is because in the
medium-to-short term, there would be coinciding forces as well as
individual market forces that will cause both stocks and gold to move in
tandem. For instance, between 2003 to 2007, stocks and gold both
rallied because of individual market forces. Stocks were underpinned by
a strengthening global economy, whereas gold was underpinned by the
dollar’s weakness, the Central Bank Gold Agreement (CBGA, 1999)
which put a cap on official sector gold-selling, and strong physical buying
from India, China. On the other hand, between 2009 and 2011, stocks
and gold both rallied because of positive coinciding forces. Both these
asset classes were supported by zero interest rates across the developed
world and massive amounts of liquidity being pumped by central banks
around the world, primarily the Fed, to revive the global economy from
the 2007-08 GFC.

Meanwhile, the chart below compares the price action of the DJIA index
and gold between 2011 and 2020:

Notice above that between September2011 and November 2015, the

DJIA index rallied sharply while gold fell sharply. The opposing
movement during this period was because of individual market forces.
Supporting the rally in stock markets were accommodative monetary
policies around the world as well as a rebounding global economy and
corporate earnings. On the other hand, adding to pressure on gold were a
strong recovery in the DXY during this period, an improving risk appetite,
and rising real rates.

Meanwhile, November 2015 to August 2018 was a period when gold

started forming a base by gradually forming higher highs and lows, partly
supported by a peak in the DXY during this period. Notice that stocks
rallied sharply during this 3-year period, with the DJIA index surging to
historic highs.

Finally, since December 2018, notice that both the DJIA index and gold
have rallied in tandem, boosted by positive coinciding forces. During this
period, both stocks and gold were supported by US interest rates topping
out and starting to head lower. In fact, with the US interest rates
dropping to zero and with the Fed taking unprecedented policy measures
since March 2020 to revive economic conditions in the US, both stocks
and gold have rallied in tandem.

From the above, we can conclude that:

From a secular-trend (long-term) perspective, stocks and gold tend to move in the
opposite direction. Periods when stocks are in a sustained uptrend are usually
accompanied by lack of interest in gold, and vice versa

From a medium-term (primary trend) to short-term (intermediate trend)

perspective, the correlation between stocks and gold is not so straight forward.
Sometimes, the two move in the opposite direction, while on other occasions they
move in the same direction

Because of the variable nature of the correlation between stocks and gold from a
medium-to-short-term perspective, one needs to closely monitor the price trends
of the two asset classes periodically to gauge whether they are moving in tandem
or counter to each other

Generally speaking, during periods of risk appetite, stocks rally and gold declines,
whereas during periods of risk aversion, stocks fall and gold rallies.

Other Correlations Summarizing the

Next 6 Lessons Correlations
Chapter In this chapter, we shall study the
two remaining intermarket
6 Lessons

n this brief chapter, we shall re-

correlations, which can add a lot of
value when tracked periodically
while also provide clues on the
overall risk appetite of market
participants. The remaining two
correlations that we will be
covering in this chapter include the
correlation between:
* Currencies and Bonds
* Currencies and Stocks
highlight the correlations that we
have studied over the course of the
previous six chapters. Note that
there is nothing new in this
chapter, but just what we have said
so far. In fact, this chapter can act
as a quick reference guide or as a
primer whenever someone wants
to refer back to the correlations
that we have discussed so far in
this module.

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Home : Intermarket Analysis and Sector Rotation

Other Correlations
In this chapter, we shall study the two remaining intermarket correlations, which can add a lot of value when tracked periodically while also
provide clues on the overall risk appetite of market participants. The remaining two correlations that we will be covering in this chapter include
the correlation between: * Currencies and Bonds * Currencies and Stocks

Abhishek Chinchalkar (31st Aug, 20)

18 minutes read

So far, we have discussed four of the most critical intermarket

relationships. These are the relationships between:

Currencies and Commodities

Commodities and Bonds

Bonds and Stocks

Stocks and Commodities

In this chapter, we shall study the two remaining intermarket

correlations, whichcan add a lot of value when tracked periodically
whilealso provide clues on the overall risk appetite of market
participants. The remaining two correlations that we will be covering in
this chapter include the correlation between:

Currencies and Bonds

Currencies and Stocks

Currencies and Bond Yields

Before starting our discussion on the correlation between the US dollar

and US treasury yields, let us start off by saying that US treasuries are
one of the safest financial instruments in the world. When we say safest,
we mean in terms of credit risk and not interest rate risk. In the modern
era, the US treasury department has never defaulted on coupon and
principle payments. Also, the US is the most powerful economy in the
world and the US dollar is the world’s reserve as well as the most liquid
currency. Because of all these factors, US treasuries are widely sought
after by various types of investors not only from the US but from other
countries as well. These investors could be individual investors,
institutional investors, or even nations themselves.

During periods of global risk aversion, there is a flight to safety across the
world. And one of the assets that tend to benefit the most during such
turbulent times areUS treasuries, as both domestic and international
investors flock these instruments. This increased demand for US
treasuries causes their price to move higher and yields to move lower.
And as the flight to safety for US treasuries increases from international
investors, so does the demand for US dollars. This is because when
international investors want to buy US treasuries, they will first have to
convert their local currencies into dollars, before they eventually
purchase treasuries. As a result, during times of heightened risk aversion,
US treasury yields tend to move lower while the dollar tends to move
higher.

Similarly, during times when economic conditions are strengthening,

investors around the world tend to move out of safer assets and into
riskier assets. In fact, during times the global economy is strengthening,
investors increase their allocation in emerging and developing markets
while reducing their allocation in developed markets, as the former tend
to offer superior returns over the latter during times of strengthening
global economy. This causes money to rotate out of US treasuries and
move out of the US. And as the demand for US treasuries reduces during
such periods, their prices decline and yields rise. Also, as international
investors withdraw their funds from the US, the supply of US dollars
increases. This is because when international investors reduce/exit their
holdings from US treasuries, they tend to covert the dollars back into
their home currencies. As a result, during times of strengthening global
economy, US treasury yields tend to move higher while the dollar tends
to move lower.

Having said that, the correlation between the dollar and US yields is not
always inverse. Above, we primarily spoke from the view point ofthe
prevailing risk flows driving movements in the dollar and US yields. First, we
spoke of a scenario wherein rising risk aversion causes international
investors to increase their holdings of US treasuries, causing US yields to
decline and the dollar to rise. Second, we spoke of a scenario whereina
strengthening global economy causes international investors to reduce
their holdings in US treasuries, pushing US yields higher and the dollar
lower. During such times, the dollar and US yields tend to move in the
opposite direction.

However, there will be circumstances wherein interest rate expectations are

driving movements in the dollar and US yields. Under such
circumstances, the dollar and US yields tend to move in the same
direction. Let us explain this more. We know that the Euro, the Yen, and
the Pound account for more than 80% of the DXY’s weight. As such, let
us focus on Euro zone, Japan, and the UK for our explanation.

If market participants expect interest rates in the US to rise relatively

more or fall relatively less than those in any of these nations, yields on US
treasuries will tend to rise more or fall less than those of the G-Secs of
each of these nations. In other words, US treasuries, because of their
higher relative yields, will become more attractive, causing global funds
to move into the US. This, in turn, will also cause the dollar to strengthen
as there will be an increased demand for the US currency.On the other
hand, if market participants expect interest rates in the US to rise
relatively less or fall relatively more than those in any of these nations,
yields on US treasuries will tend to rise less or fall morethan those of the
G-Secs of each of these nations. As a result, US treasuries, because of
their lower relative yields, will become less attractive, causing global
funds to move out of the US. This, in turn, will also cause the dollar to
weaken as there would be an increased supply of the US currency.

From the above, we can conclude that:

The correlation between the dollar and US yields is quite dynamic and depends
upon the factors that are causing the yields to move

Broadly speaking, the yields could be moving either due to prevailing risk flows or
due to interest rate expectations

If movementsarebeing driven by prevailing risk flows, US yields and the dollar

tend to move in the opposite direction

During times of rising risk aversion, international investors increase their

holdings of US treasuries, causing US yields to decline and the dollar to rise

During times the global economy is strengthening, international investors reduce

their holdings in US treasuries, causing US yields to rise and the dollar to decline

On the other hand, if movementsare being driven by interest rate expectations,

US yields and the dollar tend to move in the same direction

If market participants expect US interest rates to rise more or fall less than those
of other nations, US yields tend to rise more or fall less than those of other
nations, in turn increasing their appeal, which subsequently lifts the dollar as well

If market participants expect US interest rates to rise less or fall more than those
of other nations, US yields tend to rise less or fall more than those of other
nations, in turn reducing their appeal, which subsequently drags the dollar down

But only tracking absolute yields don’t tell the whole picture

The above chart compares the US 10-year treasury yield with the DXY
index over the last four decades. It can be seen that from a longer-term
perspective, there doesn’t seem to be much of a correlation between
yields and the DXY, as the former has steadily declined while the latter
has traded within a range, albeit a wider one, during this period. The main
reason why this is the case is because the DXY is impacted not only by
what is happening in the US but also by what is happening across each of
the other six nations. This is especially true in case of Euro zone (whose
currency occupies 58% of the DXY) and in case of Japan (whose currency
occupies14% of the DXY). What is happening in these nations also have a
strong say on the trajectory of the DXY. After all, keep in mind that
currencies are always relative and never absolute.

Instead, one must track yield spreads to analyse the trend of the
DXY

One of the best ways to see the correlation between relative yields and
the DXY is to compare the DXY with the spread between two similar
yields that have the same maturity but belong to different nations.
Examples include comparing the yield spread between US 10y and
German 10y note or that between US 2y and Japanese 2y note, etc.

The above chart compares the DXY index with the yield spread between
the US 10-year and the German 10-year note (US 10y yield – German
10y yield). Notice that this spread fluctuates above and below zero (black
line). Values above zero mean the US 10y yield is more than the German
10y yield, and vice versa. Meanwhile, a value that is equal to zero means
that the US 10y yield is at par with the German 10y yield. If the spread is
positive and rising or is negative and falling, it means the differential
between the two yields is widening. On the other hand, if the spread is
positive but declining or is negative but rising, it means the differential
between the two yields is narrowing. Let us highlight the implications of
this in a table:

+ or - ↑ or ↓ Spread is Implication
Widening in favour of
Positive Rising Bullish DXY
DXY
Positive Falling Narrowing against DXY Bearish DXY
Narrowing in favour of
Negative Rising Bullish DXY
DXY
Negative Falling Widening against DXY Bearish DXY

The reason why a rising US-German spread is bullish for the DXY is
because it makes US bonds more attractive over German bunds, causing
more money to move into the US.This in turn increases demand for the
dollars and subsequently benefits it. On the other side, a falling US-
German spread is bearish for the DXY because it makes German bunds
more attractive over US bonds, causing more money to move into
Germany. This in turn increases demand for the Euros, which
subsequently weighs on the DXY.

Coming back to the above chart, it can be seen that there is a strong
positive correlation between the DXY and the yield spread between the
US 10y and the German 10y note. Notice that the two were in a
downtrend between 1987 to 1992 and then in an uptrend between 1992
to 2000. Also see that the two were in a downtrend between 2002 to
2008 and then in an uptrend between 2011 to 2018.Another interesting
thing to note is that there is a tendency for the yield spread to change
direction before the DXY changes direction. To understand this, observe
the shaded region in the spread and the corresponding shaded region in
the DXY. Notice that the spread peaked in December 1999 and was in a
steady downtrend till September 2002. See that this narrowing of spread
from above zero eventually caused the DXY to top out in February 2002.
Similarly, notice that the spread moved above its prior peak in June 2013
and continued to move higher, which eventually caused the DXY to break
out in September 2014 and rally over the next several months. Finally,
observe that the spread peaked out in October 2018 and started
declining, which eventually caused the DXY to top out in March 2020.

From the above, we can conclude that:

As the Euro occupies a bulk of the weight in the DXY, the trend of the DXY is not
only impacted by US yields but also by German yields

One must closely monitor the spread between the benchmark 10y US yield and
the benchmark 10y German yield

A rising US-German yield spread is bullish for the DXY, as it makes US bonds more
attractive over German bunds, causing more money to move into the US.

A falling US-German yield spread is bearish for the DXY, as it makes German
bunds more attractive over US bonds, causing more money to move into Euro
zone.

That said, one needs to be aware of the lag that can and do exist between the time
the spread tops out/bottoms out/breaks out till the time the DXY follows suit

Using yield spreads to analyse the trends of currencies

Above, we talked about how one could utilize the yield spread between
the US 10y bonds and the German 10y bunds to gauge the impact it
could have on the DXY. This same logic could be applied to other
currencies as well. For instance, one could track the yield spread
between US and Japanese bonds to analyse the impact on USD/JPY or
that between US and Australian bonds to analyse the impact on
AUD/USD or that between US and Indian bonds to analyse the impact on
USD/INR, and so on. In fact, one could also track the yield spread
between two countries other than the US to gauge the impact on cross
currencies. For instance, one could track the yield spread between
Australian and Indian bonds to analyse the impact on AUD/INR or that
between German and UK bonds to analyse the impact on EUR/GBP, and
so on. Let us look at a couple of charts before moving on to the next
section:

The above chart compares the USD/JPY currency pair with the yield
spread between US 10y and Japanese 10y bonds. See that the two
usually move in sync. That is, a rising spread is positive for USD/JPY, an
vice versa. Notice that since late-2018, the spread has narrowed sharply,
which in turn has kept USD/JPY under pressure. That said, as the spread
still remains positive, notice that the downside in USD/JPY has been
limited.

Meanwhile, the chart below compares the AUD/USD currency pair with
the yield spread between Australian 10y and US 10y bonds. Again, it can
be seen that the two tend to move pretty much in tandem. That is, a rising
spread is positive for AUD/USD, an vice versa. Notice closely how a top in
the spread is followed by a top in AUD/USD. An important thing to keep
in mind is that the yield spread often acts as a leading indicator for the
currency pair, especially near tops. Also notice the region marked within
the shaded box in the spread. During this time, the spread fell into
negative, meaning the Australian 10y yield fell below the US 10y yield,
which is a relatively rare occurrence.As US treasuries are considered to
be the safest in the world, the drop in Aussie yields below the US yields
reduced their attractiveness and caused money to shift to the US, which
in turn put the Aussie dollar under severe pressure. Notice how
AUD/USD plunged and was in a downtrend during the period when the
spread was negative. The Aussiedollar eventually bottomed out at
essentially the same time the spread narrowed from negative to zero.
Since then, the spread has traded above zero, causing AUD/USD to
continue its recovery from lows.

A note of caution here. It is important to keep a track of the order in

which you are calculating the spread and the order of the currency
pairing. For instance, in this chapter, we first talked about the US 10y –
German 10y yield spread and compared it to the DXY. Since the left side
of the spread is US 10y yield and the currency in question is an index
which tracks the performance of the US dollar, there is a direct
correlation between the spread and the DXY. We then talked about the
US10y – Japanese 10y yield spread and compared it to USD/JPY. Since
the left side of the spread is US 10y yield and the base currency is also
USD, there is again a direct correlation between the spread and USD/JPY.

Put it in other words, when the left side of the spread and the left side of
the currency pair belongs to the same country, there is a direct
correlation between the spread and the currency pair. That is, a rising
spread is positive for the currency pair, and vice versa. On the other
hand, if the left side of the spread and the right side of the currency pair
belongs to the same country, there is an inverse correlation between the
spread and the currency pair. That is, a rising spread is negative for the
currency pair, and vice versa.

From the above, we can conclude that:

One can use the spread between the bond yields of two countries to analyse the
impact on the currency pair of those two countries

For instance, one can use the yield spread between US and German bonds to
analyse the impact on EUR/USD, Australian and US bonds to analyse the impact
on AUD/USD, US and Indian bonds to analyse the impact on USD/INR, and so on

It is important to keep in mind the order in which the yield spread is calculated
and the order of the currency pairing

If the left side of the spread and the left side of the currency pair belongs to the
same country, there is a direct correlation between the spread and the currency
pair

If the left side of the spread and the right side of the currency pair belongs to the
same country, there is an inverse correlation between the spread and the
currency pair

The yield spread between two countries often acts as a leading indicator for the
currency pair of those two countries

Currencies and Stocks

The correlation between the dollar and the stock markets has varied
over the years. Sometimes, the dollar and stock markets move in sync,
while at other times they move in the opposite direction. That said, since
the late-1990s, the DXY and US stock markets have mostly shared a
negative correlation. To understand this visually, let us look at the chart
below between the DJIA index and the DXY:

In the above chart, see that a falling dollar or a weak dollar has
underpinned the US stock markets. For instance, see that between late-
2002 and late-2007, a bear market in the dollar coincided with a bull
market in US stocks. Also, see that between mid-2008 and early-2014,
the dollar trading sideways but near its historic lows coincided with a
strong rally in US stocks. Finally, notice that the up turn in US stocks since
March 2020 has coincided with a downturn in the dollar. On the other
hand, periods when the dollar has risen has usually not boded well for US
stocks. For instance, observe the shaded region in the DJIA index with
the corresponding shaded region in the DXY. See that between late-1998
and early-2002, a sharp rally in the dollar increased volatility in US
stocks. Similar such behaviours occurred between early-2014 and late-
2016 and then again between early-2018 and early-2020.

One major reason for the existence of an inverse correlation between

the dollar and US equities is the dollar’s role as a safe haven. The US
currency typically tends to rally during periods of global economic
turmoil,as international investors move out of high-yielding non-dollar
denominated assets to the safe havendollar-denominated assets,
primarily US treasuries. On the other hand, the dollar typically tends to
decline during periods of global economic strength, as international
investors move their funds from safe haven dollar-denominated assets to
high-yielding non-dollar denominated assets.

The above is the short-term chart comparing key equity indices in the US
with the DXY. See that the surge in DXY in March coincided with a plunge
in US stocks. Since April however, the gradual decline in the DXY to a 2-
year low has coincided with strong recovery in the US markets. In fact,
the S&P 500 and the NASDAQ index have already surged to historic
highs during this same period. The price action this year further
highlights the negative correlation that has generally prevailed between
the DXY and US stocks since the turn of the century.

Emerging markets are more closely linked to the dollar

Compared to developed markets, emerging markets tend to offer

superior returns and high economic growth potential. However, the risks
of investing in emerging marketsalso tend to be high because of their
close ties to the fortunes of global economic growth and commodity
prices. As a result, emerging markets tend to perform strongly during
times when the global economy is strengthening and commodity prices
are rallying. Similarly, emerging markets come under stress during times
the global economy is slowing down and commodity prices are declining.
Meanwhile, previously, we said that there is a tendency for the US dollar
to advance during times of global risk aversion and decline during times
of global risk appetite. Also, we know that the dollar and commodity
prices share a strong negative correlation. Because of these factors,
emerging markets tend to be quite sensitive to the trajectory of the
dollar.

As seen in the previous section, the DXY and US stocks usually share a
negative correlation. However, this negative correlation is even stronger
with stocks from emerging markets. In other words, a rising DXY hurts
emerging markets more than it hurts the US or other developed markets.
Similarly, a falling DXY benefits emerging markets more than it benefits
the US or other developed markets.

The chart below compares the MSCI Emerging Market index with the
DXY. See the existence of a strong inverse correlation between the two.
Observe the arrows marked in the MSCI index and the corresponding
arrows marked in the DXY index. It can be seen that a bottom in the DXY
usually coincides with a top in the MSCI index. Also notice that the rally
past the trendline resistance in the DXY index in September 2014
eventually caused the MSCI index to break below the trendline support
nine months later in June 2015. Even in 2020, observe that a peak in the
DXY in March precisely coincided with a bottom in the MSCI emerging
market index. Since then, the DXY has declined while the MSCI index has
rallied.

The below chart compares the MSCI Emerging Market index with the
DJIA index. Notice that since 2010, the MSCI Emerging Market index has
strong underperformed the DJIA index – the former today is barely
above where it was in 2010, while the latter has tripled during this
period. Weakening Chinese economy, weaker commodity prices, strong
dollar, and turmoil in a few emerging market economies have caused
funds to move out of emerging markets and into developed markets over
the last decade.
The above chart compares the MSCI Emerging market index with S&P
GSCI. Notice in the chart how strongly and positively are emerging
markets and commodities interlinked.

From the above, we can conclude that:

Since the late-1990s, the DXY and US stock markets have mostly shared a
negative correlation

The US currency typically tends to rally during periods of global economic turmoil
and decline during periods of global economic strength

Emerging markets tend to be more sensitive to the trajectory of the dollar than
developed markets

Emerging markets are also extremely sensitive to trends in commodities and

usually move in tandem with commodities

A rising DXY hurts emerging markets more than it hurts the US or other
developed markets, and vice versa

Since 2010, developed markets have massively outperformed emerging markets

because of factors such as weakening Chinese economy, softening commodity
prices, strengthening dollar, and turmoil in a few emerging market economies

Summarizing the Using Ratio Charts to

Next Correlations
Chapter 6 Lessons
n this brief chapter, we shall re-
highlight the correlations that we
have studied over the course of the
previous six chapters. Note that
there is nothing new in this
chapter, but just what we have said
so far. In fact, this chapter can act
as a quick reference guide or as a
primer whenever someone wants
to refer back to the correlations
that we have discussed so far in
this module.
Identify Relative
Strength
7 Lessons
Having talked in detail about
Intermarket Analysis over the past
few chapters, it is time to move on
to the second part of this module -
Sector Rotation. In this chapter, we
will talk about a versatile tool that
can be used to identify relative
strength between one instrument
and another.

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Home : Intermarket Analysis and Sector Rotation

Summarizing the Correlations

n this brief chapter, we shall re-highlight the correlations that we have studied over the course of the previous six chapters. Note that there is
nothing new in this chapter, but just what we have said so far. In fact, this chapter can act as a quick reference guide or as a primer whenever
someone wants to refer back to the correlations that we have discussed so far in this module.

Abhishek Chinchalkar (6th Oct, 20)

5 minutes read

Over the previous six chapters, we studied six important correlations

between four tradeable asset classes namely Currencies, Commodities,
Bonds, and Stocks. These included the correlations between:Over the
previous six chapters, we studied six important correlations between
four tradeable asset classes namely Currencies, Commodities, Bonds,
and Stocks. These included the correlations between:

Currencies and Commodities

Commodities and Bonds

Bonds and Stocks

Stocks and Commodities

Currencies and Bonds

Currencies and Stocks.

In this brief chapter, we shall re-highlight the correlations that we have

studied in the previous six chapters. Note that there is nothing new in
this chapter, but just what we have said so far. In fact, this chapter can act
as a quick reference guide whenever someone wants to refer back to the
correlations that we have discussed in this module. So, let us get started.

Currencies and Commodities

There is an inverse correlation between the dollar and commodities

As the dollar strengthens, all else constant, demand for

commodities from holders of foreign currency can be expected to
weaken. As a result, rising dollar is bearish for commodities

As the dollar weakens, all else constant, demand for commodities

from holders of foreign currency can be expected to pick up. As a
result, falling dollar is bullish for commodities

In the late expansionary stage of a business cycle, commodity

uptrend tends to accelerate, which coupled with an overheating
economy raises interest rate hike expectations from the Fed. This in
turn can cause the dollar to strengthen

In the mid-to-late contractionary stage of a business cycle,

commodity price downtrend tends to accelerate, which coupled
with deceleration in economic activity raises interest rate cut
expectations from the Fed. This in turn can cause the dollar to
weaken

A rising dollar, as it tends to exert downward pressure on

commodity prices, is disinflationary

A falling dollar, as it tends to exert upward pressure on commodity

prices, is inflationary

Commodities and Bonds

Because a steady rise in commodity prices is inflationary, periods

when commodity prices are steadily climbing are usually
accompanied by rising interest rates

Because a steady decline in commodity prices is

disinflationary/deflationary, periods when commodity prices are
steadily declining are usually accompanied by falling interest rates

There is a direct correlation between commodities and bond yields

If steadily rising commodity prices fuel inflationary pressures, bond

yields tend to rise

If steadily falling commodity prices fuel disinflationary/deflationary

pressures, bond yields tend to drop

There is a strong positive correlation between copper and bond

yields

There is a negative correlation between gold and bond yields

Gold and real yields share a strong negative correlation

Crude oil strongly influences the trajectory of inflation, both

directly and indirectly

There is a positive correlation between crude oil and bond yields

Bonds and Stocks

From a secular/long-term perspective, there is an inverse

correlation between interest rates and stocks

From medium-term perspective however, there could be periods

when interest rates and stocks move in tandem depending on
factors such as the state of the economy, the level of inflation, the
positioning of the economy within the business cycle etc.

From a secular/long-term perspective, there is an inverse

correlation between bond yields and stocks

From short-term to medium-term perspective however, there could

be periods when bond yields and stocks move in tandem

The correlation between bond yields and stocks has varied over the
years. At times, the two tend to be positively correlated; while at
other times, the two tend to be negatively correlated

It is because of this that one needs to keep a close track of the

correlation between bonds yields and stocks from time to time

From 1998 to 2011, the traditional inverse correlation between

bonds yields and stocks decoupled and the two moved in tandem

Since 2011, the correlation between bond yields and stocks has
varied in a way that rising yields have benefited stocks but falling
yields haven’t had much of an impact on stocks. In fact, during
periods when yields have declined, volatility in stock markets has
shot up

Stocks and Commodities

Stocks and commodities move in sync most of the times

In a reviving/strengthening economy (i.e. between the late-

contractionary stage till the time the economy peaks out), stocks
and commodities tend to rise most of the time (with intermittent
corrections in between)

In a weakening/contracting economy (i.e. between the late-

expansionary stage till the time the economy bottoms out), stocks
and commodities tend to fall most of the time (with intermittent
recoveries in between)

Between the time the economy peaks out and enters the late-
expansionary stage, stocks and commodities tend to decouple, with
stocks starting to decline while commodities continue to rally,
before eventually topping out and joining stocks lower

Between the time the economy bottoms out and enters the late-
contractionary stage, stocks and commodities tend to decouple,
with stocks starting to rally while commodities continue to fall,
before eventually bottoming out and joining stocks higher

From 1994 to 2011, the traditional correlation between

commodities and stocks held strongly

Between 2011 and 2019, commodities and stocks moved in the

opposite direction, with commodities falling due to strengthening
dollar & weakening Chinese economy and equities rising due to
ultra-low interest rates

Since early-2020, the traditional correlation between commodities

and stocks seems to have resumed

Currencies and Bonds

The correlation between the dollar and US yields is quite dynamic

and depends upon the factors that are causing the yields to move

If movements are being driven by prevailing risk flows, US yields

and the dollar tend to move in the opposite direction

On the other hand, if movements are being driven by interest rate

expectations, US yields and the dollar tend to move in the same
direction

As the Euro occupies a bulk of the weight in the DXY, the trend of
the DXY is not only impacted by US yields but also by German yields

A rising US-German yield spread is bullish for the DXY, as it makes

US bonds more attractive over German bunds, causing more money
to move into the US

A falling US-German yield spread is bearish for the DXY, as it makes

German bunds more attractive over US bonds, causing more money
to move into Euro zone

One can use the spread between bond yields of two countries to
analyse the impact on the currency pair of those two countries

In fact, the yield spread between two countries often acts as a

leading indicator for the currency pair of those two countries

Currencies and Stocks

Since the late-1990s, the DXY and US stock markets have mostly
shared a negative correlation

The US currency typically tends to rally during periods of global

economic turmoil and decline during periods of global economic
strength

Emerging markets tend to be more sensitive to the trajectory of the

dollar than developed markets

Emerging markets are also extremely sensitive to trends in

commodities and usually move in tandem with commodities

A rising DXY hurts emerging markets more than it hurts the US or

other developed markets, and vice versa

Since 2010, developed markets have massively outperformed

emerging markets because of factors such as weakening Chinese
economy, softening commodity prices, strengthening dollar, and
turmoil in a few emerging market economies

Using Ratio Charts to Top-Down Approach: The

Next Identify Relative Technical Way
Chapter Strength
7 Lessons
5 Lessons

In this Chapter, we will discuss how

Having talked in detail about
Intermarket Analysis over the past
few chapters, it is time to move on
to the second part of this module -
Sector Rotation. In this chapter, we
will talk about a versatile tool that
can be used to identify relative
strength between one instrument
and another.
one could use the Top Down
Approach using Technical and
Intermarket Analysis. The
objective of this approach is to
scan from the top to the bottom, so
as to find out the strongest
markets/sectors and the strongest
stocks within those
markets/sectors where capital
could be deployed and a portfolio
of stocks could be created.

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Using Ratio Charts to Identify Relative Strength

Having talked in detail about Intermarket Analysis over the past few chapters, it is time to move on to the second part of this module - Sector
Rotation. In this chapter, we will talk about a versatile tool that can be used to identify relative strength between one instrument and another.

Abhishek Chinchalkar (20th Oct, 20)

11 minutes read

Having talked in detail about Intermarket Analysis, we now move to the

second part of this module -Sector rotation. In this chapter, we will talk
about a versatile tool that can be usedwhen making decisions relating to
trading and investing. This tool helps in identifying the relative strength
between one instrument and another.Knowing the relative strength
facilitates one to trade or invest smartly, by reducing exposure to assets
that are underperforming their benchmarks and increasing exposure to
assets that are outperforming their benchmarks.

Ratio Analysis basics

Ratio Analysis, also known as Relative Strength Analysis, involves a

comparison between two instruments to identify their relative
performance. It is calculated by dividing the price of one instrument with
that of the other. A ratio chart (aka relative strength chart) is plotted on a
continuous, real-time basis and is usually done so in the form of a line
chart. Usually, the numerator in the ratio consists of an instrument whose
performance you want to compare with the other. For instance, if you
want to see how Reliance Industries is faring vis-à-vis the Nifty, you will
place Reliance in the numerator and Nifty in the denominator, and then
plot a continuous, real-time chart. If the ratio line is rising, it means the
numerator is outperforming the denominator; and if the ratio line is
falling, it means the numerator is underperforming the denominator.
Meanwhile, an interesting thing about ratio analysis is that on a ratio
chart, you could use all the tools that you use when analysing absolute
price charts. For instance, on the ratio chart, you could use trendlines and
channel lines, fibonacci retracement and extension, price patterns,
moving averages, technical indicators, harmonics etc.

Keep in mind that Ratio charts do not say anything about the absolute
direction of prices, but just the relative direction. For instance, let us take
the earlier example of Reliance and Nifty. If the ratio line of Reliance to
Nifty is rising, it doesn’t necessarily mean Reliance is rising or Nifty is
falling, but just that Reliance is outperforming Nifty, regardless of the
direction of the two. In order to know the absolute direction of prices,
one has to refer back to the absolute price charts of individual
instruments.

A rising ratio line could imply any one of the following:

Numerator is rising, while denominator is falling

Numerator is rising, while denominator is unchanged

Both are rising, but numerator is rising more than the denominator

Numerator is unchanged, while denominator is falling

Both are falling, but numerator is falling less than the denominator

Similarly, a falling ratio line could imply one of the following:

Numerator is falling, while denominator is rising

Numerator is falling, while denominator is unchanged

Both are falling, but numerator is falling more than the denominator

Numerator is unchanged, while denominator is rising

Both are rising, but numerator is rising less than the denominator

There are various ways in which the numerator and the denominator can
be chosen for performing a relative strength analysis. Below mentioned
are some of the most followed ways of measuring relative strength
between two instruments:

Stock vs. Stock (example, Infosys vs. TCS)

Stock vs. Sector (example, Infosys vs. IT Sector)

Stock vs. Market (example, Reliance vs. Nifty)

Sector vs. Sector (example, Banking vs. IT)

Sector vs. Market (example, Pharma vs. Nifty)

Market vs. Market (example, Nifty vs S&P500)

Asset vs. Asset (Gold vs. Nifty)

In the next chapter, we shall talk about how to use each of the above
mentioned ratiocharts in great detail, so as to get a holistic view of the
overall markets. In this chapter however, let us just focus on one of the
ratiosdescribed above to get a broad sense of how to analyse ratio charts.
Let us talk about the ratio chart of stock versus stock. Keep in mind that
the manner in which the ratio chart of stock versus stock is analysed
apply, in general, to each of the other six ratio charts mentioned above.

Ratio analysis of Stocks vs. Stocks

One would perform a ratio analysis on one stock vis-à-vis another to

analyse which of the two is performing better. If the ratio line is rising, it
implies the stock in the numerator is outperforming the stock in the
denominator, and vice versa. This type of analysis is typically used either
when:

A trader/investor wants to buy the security that is outperforming

and sometimes even simultaneously sell the security that is
underperforming, or

A trader/investor wants to narrow down on the number of stocks

that he/she is willing to buy

In case of the first (using ratio chart to buy one and sell the other), there
is not much of a need to see the absolute charts of the two securities. The
trader/investor could just buy the stock that is outperforming and
simultaneously sell the other. He would hold on to this trade until there is
evidence that the ratio is reversing.

However, in case of the second (using ratio chart to buy only one of the
twostocks without selling the other), the trader/investor must look at the
absolute charts as well, to ensure that the one he/she is buying is in an
uptrend and not in a downtrend (Recollect from the Technical Analysis
module that you would want to trade/invest in the direction of the trend
– buying a security that is in an uptrend, and vice versa).Let us try to
understand this using an example.

Example 1:

Buying the outperformer and simultaneously selling the other

The above is the long term ratio chart of HDFC Bank to SBI (Numerator =
HDFC Bank and Denominator = SBI). Both are stocks that belong to the
banking space, with SBI a part of PSU banks and HDFC a part of private
banks. It can be seen that the ratio line broke out of a channel in mid-
2011 after almost four years of consolidation, suggesting that HDFC
Bank is likely to outperform SBI as long as the ratio remains above the
channel. Following this breakout, a trader could have bought HDFC Bank
and simultaneously shorted SBI. Observe that post the breakout in May
2011, the ratio more than doubled inside the next three years.Also
observe that the ratio has been in a strong uptrend since late-2014. A
trend line is drawn connecting the two lows of 2014 and 2016 and then a
parallel line to the main trend line is drawn from the high of 2016. One
way atrader could have traded this set up is by buying HDFC Bank and
simultaneously shorting SBI when the ratio bounced off the trend line on
the third occasion (marked using the green arrow) and then exiting these
positions as the ratio started to decline off the parallel line (marked using
the third red arrow). A risky trader could also have considered shorting
HDFC Bank and simultaneously buying SBI on the two occasions when
the ratio turned down from the parallel line (marked using the red
arrows) and then exiting these positions near the trend line support. This
type of trading, however, is more suited to an active trader/investor
rather than a passive trader/investor. Notice that the ratio broke above
the parallel line in 2020 and later took support at that parallel line,
indicating at strong performance of HDFC Bank relative to SBI.

Only buying the security that is outperforming without selling

the other

Keep in mind that ratio charts tell nothing about the absolute trend of
individual stocks, but just their relative trend. Let us again take the above
example of HDFC Bank/SBI ratio chart. As we saw above, the ratio has
been in anuptrend since the consolidation breakout in 2011. However,
just by looking at the ratio chart, you cannot say anything about the
absolute trends of each of the two stocks. A rising ratio line does not
necessarily mean that the numerator is rising, but just that it is
outperforming the denominator. A ratio line canrise even whenboth the
stocks in question are falling. As a result, it is critical to have a look at the
individual stock charts in question, when the objective of the
trader/investor is to only buy the stock that is outperforming, without
simultaneously selling the other. Continuing with the above example, let
us look at the individual chart of SBI and HDFC Bank.

Looking at the absolute charts of the two, the vertical black line marked
above displays the period when the ratio broke out of consolidation.
Since then, see that HDFC Bank has been in a strong uptrend, while SBI
has been broadly consolidating. As the ratio and HDFC Bank haveboth
been in an uptrend, it tells that if the trader/investor wants to buy just
one of the two stocks, he or she should be buying HDFC Bank as long as
there is no evidence of a reversal in the ratio.

Example 2:

Let us now switch from the banking space to the Technology space. The
chart below is the absolute chart of TCS and Infosys. It can be seen from
the chart that both the stocks have been in a strong uptrend since
2008.It can also be seen that both Infosys and TCS have been in a
powerful uptrend over the last few weeks.Let us now focus on the
current scenario rather than the historical scenario.

If a trader or an investor just wanted to buy one of the two stocks, what
should he or she be buying? It seems difficult to take a decision just on
the basis of absolute charts of the two stocks. So, in order to decide on
this, let us look at what the ratio chart of the two has to say. Let us keep
TCS in the numerator and Infosys in the denominator. The chart below
shows the ratio chart of the two stocks.

Above, it can be seen that the ratio line was in an uptrend between 2009
and 2020 beforebreaking below a 10-year rising trendline earlier this
year. What this essentially tells is that as long as the ratio line is trading
below the trendline, TCS could underperform Infosys. So, if the
trader/investor wants to buy only one of the two stocks, then based on
this ratio chart, he or she should prefer Infosys over TCS until the time
the ratio line is below the rising trendline.

Example 3:

The above chart is the ratio chart of Maruti to Mahindra and Mahindra
(M&M). Both are stocks that belong to the 4-wheeler space. Notice in the
middle and the bottom panel that both Maruti and M&M broke above
their respective falling resistance lines. This indicates at price strength.
However, by just looking at the absolute chart, it is difficult to say which
of the two would perform better. The top panel compares the ratio of the
two (Maruti is in numerator and M&M is in denominator). From March
2020 to July 2020, M&M strongly outperformed Maruti, as can be seen
by a steep decline in the ratio. However, the ratio line has bounced off an
important trend line support. I call this trend line important because it
has been unbroken since 2014 and has also been tested several times.
The bounce off it suggests that Maruticould now start outperforming
M&M as long as the trendline support remains intact. So, while the
absolute chart of the individual stocks both look bullish, the ratio chart
suggests that Maruti could outperform M&M.

This is how one can effectively combine absolute charts of two stocks
with the ratio chart to analyse the relative performance. Needless to say,
all the charts that are presented above are for the purpose of explaining
the concept of relative strength only and should not be construed as a
trading or investing recommendation.

As stated earlier, the objective of this chapter was to only introduce and
discuss the basics of Ratio Analysis. In the next chapter, we shall
extensively talk about how to use Ratio analysis charts, so as to get a
holistic view of the overall markets.

Let us now conclude this chapter by highlighting the key learnings:

Ratio Analysis, also known as Relative Strength Analysis, involves a comparison

between two instruments to identify their relative performance

It is calculated by dividing the price of one instrument with that of the other.
Usually, the numerator consists of an instrument whose performance you want to
compare with the other

If the ratio line is rising, it means the numerator is outperforming the

denominator; and if the ratio line is falling, it means the numerator is
underperforming the denominator

An interesting thing about ratio analysis is that on a ratio chart, you could use all
the technical tools that you would use when analysing absolute price charts, such
as trendlines, fibonacci, moving averages, technical indicators, harmonic patterns
etc.

Keep in mind that Ratio charts do not say anything about the absolute direction of
price, but just the relative direction

To check the absolute direction of price, one has to refer back to the absolute
price charts of individual instruments

When using ratio analysis, one could choose to buy the outperforming stock and
simultaneously sell the underperforming stock. In this case, there is not much of a
need to see the absolute charts of the two stocks

Alternatively, one could also choose to buy only the outperforming stock without
selling the other stock. In this case, one must look at the absolute charts as well,
to ensure that the stock he/she is buying is in an uptrend and not in a downtrend

Preferably, when doing relative strength analysis between two stocks, ensure
that the two stocks belong to the same sector, like the ones shown in the charts
above

Top-Down Approach: The Top-Down Approach:

Next Technical Way Real World Application
Chapter 5 Lessons 4 Lessons

In this Chapter, we will discuss how Continuing from the previous

one could use the Top Down chapter, in this chapter, we shall
Approach using Technical and talk about the practical application
Intermarket Analysis. The of the Top Down approach on the
objective of this approach is to Indian markets/sectors and stocks,
scan from the top to the bottom, so and how one could build a trading
as to find out the strongest portfolio using this approach.
markets/sectors and the strongest
stocks within those
markets/sectors where capital
could be deployed and a portfolio
of stocks could be created.

Responses
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Home : Intermarket Analysis and Sector Rotation

Top-Down Approach: The Technical Way

In this Chapter, we will discuss how one could use the Top Down Approach using Technical and Intermarket Analysis. The objective of this
approach is to scan from the top to the bottom, so as to find out the strongest markets/sectors and the strongest stocks within those
markets/sectors where capital could be deployed and a portfolio of stocks could be created.

Abhishek Chinchalkar (15th Feb, 21)

8 minutes read

Now that we have a broad idea of what Relative Strength Analysis (aka
Ratio Analysis) is, let us take our understanding one step ahead and talk
about the practical application of Ratio Analysis. In this chapter, we shall
focus on how one could use the Top Down Approach technically. As the
name suggests, the objective of this approach of trading is to scan from
the top to the bottom so as to find out the strongest markets/sectors and
the strongest stocks within those markets/sectors. We shall talk in detail
about this over the next two chapters.

The Top Down Approach

The Top Down approach is a versatile method of stock selection. As you

might have guessed from the name, the Top Down approach proceeds
from the top and drills all the way down to the bottom. It is akin to taking
an eagle’s view from the top. The TopDown approach is mostly used
fundamentally, wherein the overall state of the economy is identified
first, and then based on that, appropriate sectors and stocks are chosen.
That said, the Top Down approach can also be used Technically, which we
shall do over the course of this chapter.

Broadly speaking, the Top Down Approach using charts can be split into
four stages as follows:

Stage 1: Analyzing Global Market trends

In the Top Down approach, the trader first starts by analysing the
absolute charts of each of the four tradable asset classes i.e., stocks,
commodities, currencies, and bonds. If you have read the previous
chapters in this module, you will know that the trend of each of these
asset classes signal a lot about the state of the economy and market
sentiment. For instance, periods during which stocks, commodities, and
bond yields are all rising simultaneously typically coincide with
strengthening economic conditions, and vice versa. Meanwhile,
movements in the Dollar Index (DXY) and the CBOE Volatility Index (VIX)
tell a lot about the prevailing risk sentiment. Typically, a strengthening
DXY and a rising VIX coincides with risk aversion, and vice versa.
Furthermore, within asset classes too, the performance of one vis-à-vis
the other can indicate a lot. For instance, periods when copper or crude
oil is outperforming gold or periods when commodity currencies are
outperforming other currencies or periods when more capital is flowing
into emerging markets than into developed markets typically coincide
with a strengthening global economy, and vice versa. In short, by looking
at the price trends of various assets, you can gain strong insights about
the overall economic and market conditions. Hence, before trading,
always get into the habit of tracking the price trends of various asset
classes.

One of my favourite combination is to look at the monthly, weekly, and

daily individual charts of the following instruments:

Nifty 50 index

S&P 500 index

DXY index

US 10y bond yield

Gold

Copper

Crude oil

VIX

The monthly, weekly, and daily time frame chart would tell the larger-
term, medium-term, and shorter-term trends of each of these asset
classes. If you are a short-term trader, you could skip the monthly and
weekly time frame and instead focus on the daily and intraday time
frame.

These individual charts would provide information about global market

conditions and risk sentiment. However, when comparing between two
securities, absolute charts will not provide much information about the
relative performance, especially when they are moving in the same
direction. That is where ratio charts come into the picture. Besides
providing information about whether one security is outperforming or
underperforming the other, ratio charts provide further insights about
the state of the market and the level of risk appetite. As such, after
looking at the individual charts, one needs to look at the daily ratio charts
as well.Some key ratio charts that are worth tracking are:

S&P 500 index to GSCI Commodity index

MSCI Emerging Market index to S&P 500 index

Gold to Copper

You could scan other macro-ratio charts as well, depending on your

preference and expertise. The point is that knowing the trajectory of
each of these macro ratios can help considerably in selecting the right
and appropriate local markets/sectors and stocks. We will talk about
each of these in more detail going forward.

Stage 2: Drilling down to Indian markets and sectors

As you saw in stage 1, most of the analysis revolved around the global
markets. You may ask, why to focus on global markets when we are
trading in Indian stocks. Well, the answer is because Indian markets are
tightly linked to the global markets and tend to move very much in sync
with them (see the chart below). Hence, it is extremely critical to keep a
track of developments across the world, most notably the US.

After scanning the individual and ratio charts of major global asset
classes, the second stage is to drill down to the Indian markets and
sectors. There are two ways in which this can be done.

The first way (I call this the market approach) is to compare the ratio charts
of broader market indices with a largecap index (such as Nifty or Sensex).
For example, one could compare the ratio chart of:

Nifty Midcap 100 to Nifty 50

Nifty Smallcap 100 to Nifty 50

Nifty Midcap 100 to Smallcap 100

Doing so enables the trader to gauge how the broader markets are faring
relative to largecaps. If they are outperforming largecaps, it informs the
trader to allocate a greater portion of their funds to stocks from the
broader markets. Conversely, if they are underperforming largecaps, it
tells the trader to allocate a greater portion of their funds to stocks from
the largecap space.

The second way (I call this the sector approach) is to compare the ratio
charts of sectoral indices with a largecap index. Below mentioned are
some of the sectoral indices listed on the NSE:

Bank

Auto

Financial Services

FMCG

Information Technology

Media

Metal

Pharma

PSU Bank

Private Bank

Realty

A trader needs to compare each sectoral index with the Nifty 50 index.
Doing so allows one to identify which sectors are performing the best
relative to the markets and which are performing the worst. Remember,
the idea is to deploy capital in the strongest possible sectors.

As you can see, under the 1st approach, you would look at the broader
markets (midcaps and smallcaps), compare them with a benchmark index
(Nifty), and accordingly decide the capital allocation among largecaps,
midcaps, and smallcaps. In other words, you will create positions not on
the basis of strongest market sectors, but rather on the basis of the
market index showing the greatest strength, both absolute and relative.
On the other hand, under the 2nd approach, you would look at the
sectoral indices, compare them with a benchmark index, and accordingly
decide the capital allocation across sectors.

Irrespective of which of the two ways is chosen, it goes without saying

that besides looking at the ratio charts, one must also look at the
absolute charts of the broader markets/sectoral indices. This is because
while the ratio charts tell a lot about relative performance, they tell
nothing about absolute performance. While deploying capital, just
knowing the relative direction would not suffice. One must know the
absolute direction as well. For example, let us assume that by looking at
the ratio chart, we find out that broader markets are outperforming
largecaps. However, as we said in the previous chapter, this
outperformance can happen even at a time when markets in general are
declining. But would it make sense to deploy capital in a falling market?
Probably not. Hence, it is critical to know about the direction of the
absolute trend as well and not just the relative trend.

Stage 3: Stock Selection from outperforming Markets or Sectors

After getting a holistic view of the overall markets (stocks, commodities,

currencies, and bonds) and then identifying the markets or sectors that
are looking the most promising, the third stage in the Top Down
approach is stock identification and selection. Again, the idea is to select
stocks from markets or sectors that you feel would perform the best
going forward. But of course, as the saying goes, it is not a good idea to
keep all your eggs in one basket. That is, one should not select only one
market/sector that is performing the best and deploy the entire capital
into that one market/sector. Instead, a trader should diversify holdings
across a few other markets/sectors that are showing good absolute as
well as relative strength. One must also deploy a certain percent of the
overall capital into stocks from sectors that are considered defensive, as
doing so can offer cushion during periods of heightened volatility. All
these would reduce exposure to any unexpected market/sector-specific
risks.

Even within markets/sectors that are showing strong absolute as well as

relative strength, not all stocks will be performing equally well. There will
be some that are outperforming their respective markets/sectors, some
that are underperforming, and some that are performing at par. Hence,
within markets/sectors as well, further filtering is needed. The trader
must look at the absolute chart of each stock as well as the relative chart
of each stock versus the market/sector of which it is a part of, and then
deploy funds into only those stocks that are not only in an uptrend but
are also outperforming their respective market/sector.

Stage 4: Monitoring the portfolio and ensuring proper risk

management

The Top Down approach does not end once each of the above three
stages are complete and a portfolio of stocks has been established. Once
the trader has bought the most promising stocks from the most
promising markets/sectors, only half of the job is complete. The other
half of the job is to regularly monitor the overall markets (restarting from
Stage 1 to 3) as well as ensure that right risk management measures are
in place to protect the capital deployed. This is a process that should
continue forever. If there are changes in market conditions, the trader
will have to make necessary adjustments in his/her portfolio of stocks to
reflect those changes. For instance, if a trader observes that the
strongest market/sector is losing momentum and market leadership is
shifting to some other market/sector, he or she may need to make
necessary adjustments to his/her portfolio to reflect those changes. This
is a part of actively managing the portfolio.

Before concluding this chapter, let us summarize the four stages of Top
Down Approach, using the Technical way:

In the next chapter, we will put to practice what we have studied in this
chapter. That is, we will talk about the real world application of the Top
Down Approach using the Technical Way.

Top-Down Approach:
Next Real World Application
Chapter 5 Lessons

Continuing from the previous

chapter, in this chapter, we shall
talk about the practical application
of the Top Down approach on the
Indian markets/sectors and stocks,
and how one could build a trading
portfolio using this approach.

Responses
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Reproduction of the materials, text and images are not permitted.
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by FYERS

Home : Intermarket Analysis and Sector Rotation

Top-Down Approach: Real World Application

Continuing from the previous chapter, in this chapter, we shall talk about the practical application of the Top Down approach on the Indian
markets/sectors and stocks, and how one could build a trading portfolio using this approach.

Abhishek Chinchalkar (23rd Feb, 21)

15 minutes read

Continuing from the previous chapter, let us now talk about the practical
application of the Top Down approach on Indian markets/sectors and
stocks. For our illustration, let us take the price action in 2020 and see
what we can decipher from the charts.

Stage 1: Analyzing Trends in Global Markets

As stated previously, the first stage involves looking at the absolute as

well as relative charts of major global asset classes. Let us do so now. The
assets that we will consider for our illustration are the Nifty 50 index,
S&P 500 index, DXY index, US 10-year Treasury yield, Gold, Copper,
Crude oil, and CBOE VIX. So, let us go ahead and look at the individual
charts first.

Notice the above charts. This depicts the price action during the first half
of 2020. It can be seen that each of S&P 500, Nifty 50, Gold, and Copper
formed a higher low – higher high sequence in early April, following a
precipitous fall over the past few weeks. Crude oil prices also bottomed,
albeit with an element of time lag. Meanwhile, the DXY and VIX peaked
out towards the end of March, following a near vertical rise; while the US
10-year yield bottomed out in the early parts of April, following a plunge
to record lows. All these intermarket and Technical factors occurring
within a time span of a few days suggested that financial stresses are
receding and that a recovery could get underway. Let us now look at a
couple of macro ratio charts to see what they were suggesting during this
period.

Notice above that the equity outperformance relative to commodities

peaked out towards the end of April, following which commodities
started outperforming. As Emerging Markets are major consumers of
commodities, the reversal in this ratio can be construed as an early sign
that economic conditions in EMs are reviving and that the business cycle
could be turning up. This bodes well for riskier assets. Meanwhile, the
breakdown in the Gold/Copper ratio in May suggested that an industrial
commodity is starting to outperform a safe haven. This is again a signal of
improving risk appetite. In a nutshell, the unfolding developments during April
and May 2020 could be construed as a signal that riskier assets are returning in favour.
Now that we have a broad overview of global markets and risk appetite, let us look at
how one could have capitalised the trends that unfolded between April and May 2020.

Stage 2: Drilling down to Indian markets and Sectors

As said in the previous chapter, there are two ways of doing this. The first
is the market approach and the second is the sectoral approach. You
could choose any one or even both of the approaches.

Market Approach:

Let us look at the absolute and relative charts of Nifty Midcap 100 and
Smallcap 100 index.

The above is the absolute price chart of the Nifty Midcap 100 index and
the Nifty Smallcap 100 index. It can be seen that both the indices,
following a precipitous fall, bottomed out in March and made a higher
low – higher high sequence in April. This sequence essentially coincided
with a similar sequence that was made by Nifty, as was saw earlier. Just
by looking at the absolute chart, we can see that the swings and the
trajectory of Nifty 50, Midcap 100, and Smallcap 100 are quite similar to
each other. Hence, it is difficult to conclude at hindsight whether
Midcaps and Smallcaps are outperforming Nifty or is it the other way
around. It is for this reason that one needs to look at ratio charts as well,
to understand whether one instrument is underperforming or
outperforming the other and the degree of this
outperformance/underperformance. Let us now look at the ratio charts.

Notice from the above charts that each of Midcap 100 and Smallcap 100
index started outperforming Nifty once the markets bottomed.
Meanwhile, between Midcap 100 and Smallcap 100, see that Smallcaps
started outperforming Midcaps. What do these ratio charts tell us? They
tell us that Smallcaps are outperforming Midcaps, which in turn are
outperforming the Largecaps. This in turn suggests that a trader should deploy a
greater percent of his/her capital into Smallcaps, then into Midcaps, and finally the rest
into Largecaps.

Sectoral Approach:

Let us look at the ratio and absolute charts of sectoral indices.

Keep in mind that Indian markets bottomed out towards the end of
March 2020 and henceforth started recovering. From the above
individual and ratio charts, see that Auto and Metal were the first sectors
that started outperforming Nifty from early May; while IT and Pharma
were already outperforming Nifty, even during the market downtrend.
Meanwhile, each of Financial Services, Realty, Private Bank, and PSU
Bank were laggards and started outperforming Nifty much later. On the
other hand, the FMCG sector started underperforming Nifty just as
other sectors were starting to outperform. What do all these charts tell
us? They tell us that once the market bottomed and started recovering from April
2020, the sectors that led the market recovery were IT, Pharma, Auto, and Metal.
Hence, these are the sectors that could be considered for deploying capital during the
early stages of market recovery.

Stage 3: Stock selection from outperforming Markets or Sectors

Now that we are aware of the trends that were unfolding across the
global markets as well as across the Indian markets and sectors between
April and May 2020, the next stage is to start screening stocks,
depending on the approach chosen - market or sectoral. But before
proceeding towards discussing each of these, let us first talk about an
important concept called Position Sizing.

Position Sizing:

As the name suggests, Position Sizing refers to deciding the size of each
position within a portfolio of securities. Some of the key objectives of
Position Sizing are:

To determine the number of stocks to buy

To manage portfolio risks efficiently and effectively

There are several ways in which a trader can choose Position Sizing
depending upon the capital deployed and the portfolio risks that the
trader is willing to take. In here, we will discuss two widely used methods
of Position Sizing.

Method 1: Equal Rupee allocation

Under this method, equal money is allocated to each position within a

portfolio. How much money is allocated for a position depends on several
factors, such as a trader’s objective, capital size, extent of diversification
to be achieved etc. Let us take a simple example. Let us assume that a
trader has a capital of ₹1 lac and has decided to deploy ₹20,000 per
stock. Based on this, a trader would be deploying his capital in 5 different
stocks (₹1,00,000/₹20,000). As it may not always be possible to deploy
exactly ₹20,000 in each stock (because the market price per share may
not be exactly divisible by ₹20,000), small differences are acceptable.
Also, in this case, see that a trader will not be able to buy a stock that is
currently selling for more than ₹20,000 per share (such as MRF and Page
Industries). If a trader intends to achieve greater diversification, he must
deploy lesser capital per position, such as ₹10,000 instead of ₹20,000,
and vice versa.

Let us take a simple example now. Let us assume that we have looked into
the chart of ICICI Bank and expect it to rise going forward. At the
prevailing price of ₹645 per share and an allocation of ₹20,000 per
position, a trader would be able to buy 31 shares of ICICI (₹20,000/₹645,
rounded down to the nearest integer). So, the total capital invested in
this position is ₹19,995 (₹645 * 31). Coming to the risk management part,
the trader must now decide the stop loss for the trade. Keep in mind that
the stop losses chosen must not be random but rather logical and based
on the past price action. Let us assume that the trader sees an important
support converging near ₹597 and likewise decides to place a stop loss at
₹595. In case the stock moves contrary to expectations and hits ₹595,
the position would be exited, and the trader would suffer a loss
amounting to ₹1,550 ((₹595 - ₹645) * 31). In a similar way, the trader
would deploy ₹20,000 in each of the other 4 stocks.

Below is a sample illustration of Portfolio sizing done using Equal Rupee

approach. Total capital deployed is ₹1 lac, which is then evenly
distributed across 5 different stocks (₹20,000 per position). Notice how
the capital deployed per stock is nearly identical.

Method 2: Equal Risk allocation

Under this method, equal risk is allocated to each position in the

portfolio, while the amount of capital deployed in any one position varies
depending upon the stop loss chosen for each stock in the portfolio. Now
contrast this method to the previous, in which equal capital was allocated
to each position. In this method, the risk per position as a percent of the
total capital deployed is fixed. Ideally, this risk should not exceed 2% of
the total capital, as doing so would significantly increase portfolio risks in
case of adverse market movements. Instead, the risk should ideally be
capped at 0.5% or 1% of the total capital. For our illustration, let us
assume that the total capital to be deployed is ₹1 lac and that the risk the
trader is willing to take per position is 1% of the total capital. This turns
out to be ₹1,000 per position (1% of ₹1,00,000).

Let us take the example of ONGC. After reviewing the chart, let us
assume that the trader expects the stock to rise going forward. Let us
assume that he/she wants to buy at the prevailing price of ₹95 per share.
From the chart observation, the trader is of the opinion that his/her
bullish view would stand negated in case the price drops to ₹87.50.
Hence, he/she is willing to place a stop loss at ₹87. So, the risk per share
is ₹8 (₹87 - ₹95). Given that the trader has decided to cap his/her losses
to ₹1,000 per position, the number of shares of ONGC that he/she can
buy, such that the loss amounts to exactly ₹1,000, is 125 (₹1,000 ÷ 8). See
that in case the stop loss is hit, the trader would exit the position at ₹87
and suffer a loss of ₹1,000 ((₹87 - ₹95) * 125). In a similar way, you would
cap your risk to ₹1,000 per position for each of the other stocks that you
have bought. Remember, the total capital deployed at any point would be
₹1 lac or less.

Below is a sample illustration of Portfolio sizing using Equal Risk

approach. Total capital deployed is ₹1 lac and risk per trade is 1% of the
total capital.

Before jumping back to the Top Down approach, let us summarize the
key differences between the two Position Sizing methods discussed
above:

Now that we understand the basics of Position Sizing, let us come back to
our topic of discussion, stage 3 of the Top Down approach.

Market Approach:

If market approach is chosen, the trader must decide on the allocation

that would go into smallcaps, midcaps, and largecaps. For our example,
based on our interpretation from Stage 1 and 2, let us select a 40%, 35%,
and 25% allocation to smallcaps, midcaps, and largecaps, respectively. Let
us also assume the total deployable capital is ₹4 lacs. Out of this,
₹1,60,000 would go into Smallcaps, ₹1,40,000 into Midcaps, and
₹1,00,000 into largecaps. To decide on position sizing within each of
Smallcaps, Midcaps, and Largecaps, a trader could resort to one of the
two methods discussed above or implement his/her own position sizing
strategy. For our case, let us assume that the trader has decided to
deploy ₹20,000 per position in each of the three markets. That means the
trader would be buying 8 smallcap stocks, 7 midcap stocks, and 5
largecap stocks, for a total of 20 stocks. Now that the allocation has been
decided, the trader must scan all the stocks (250 in total) from each of
the three indices, with the objective of selecting 8 smallcap, 7 midcap,
and 5 largecap stocks that he/she believes would perform the best going
forward.

For stock screening and filtering, one could use fundamental parameters,
technical parameters, quantitative parameters, or a combination. There
are various ways in which stocks can be screened, filtered, and selected.
One such example is to deploy a three step approach for filtering and
selecting the stocks to buy, as follows:

Step 1 (Initial Screening and Filtering): Initially, one could start by

filtering out those stocks from the chosen universe that do not fit in
the selection criteria. What could this stock elimination criteria be?
Well, that varies from traders to traders. A few examples include
eliminating those stocks from the universe that are trading below
their 20-day MA, those that are priced above a certain level (say
₹5,000 per share), those that are less liquid etc. Several such criteria
could be deployed to remove ineligible stocks. Once the ineligible
stocks are out, the trader must then quickly scan the charts of each
of the remaining stocks from the respective index and filter out
those that are underperforming the markets and are not looking
promising. The objective of this step is to eliminate at least 60-70%
of the stocks from the universe, so that we are left with just a few
handful of good stocks.

Step 2 (Further filtering and final stock selection): Once the stock
list has been narrowed down, again look into the charts of all the
remaining stocks, but this time in a much more detailed manner,
including looking at the ratio charts of a stock versus the index of
which it is a part of. If you are confused of deciding which one stock
to select among two or three, you could even look at the ratio chart
of one stock versus another stock from the same index, so as to
eliminate the one that is showing weak relative strength. The
objective of this step is to eliminate all the remaining stocks and
retain only those that would be on your final buy list.

Step 3 (Determining Entry, Quantity, Stoploss, and Target): Once

the final stock selection is done and you have decided which of the 8
smallcap, 7 midcap, and 5 largecap stocks to buy, the final step is to
identify the entry level for each trade, quantity of each stock to be
purchased, the stoploss for each trade, and the target price for each
trade. Keep in mind that the risk to reward ratio must be attractive
before entering the trade.

To reiterate, shown below is a sample three-step process of how one

could filter and select stocks from a universe:

Sectoral Approach:

On the other hand, if the sectoral approach is chosen, the trader must
decide on the allocation that would go into IT, Pharma, Auto, and Metal
sector. For our illustration, let us allocate 25% to each sector. Let us also
again assume the total deployable capital to be ₹4 lacs. This means ₹1 lac
will go into each of the four sectors. For position sizing, let us assume that
the trader has decided to deploy ₹20,000 per position in each sector.
That means the trader would be buying 5 stocks from each sector, for a
total of 20 stocks. Now that the allocation has been decided, we must
scan all the stocks, sector wise (50 in total), with the objective of buying 5
stocks each from the IT, Pharma, Auto, and Metal space. Again, the trader
could use the three step approach mentioned above to screen, filter,
select stocks, and define the entry and exit criteria for each of the five
stocks from each of the four sectors.

Stage 4: Monitoring the portfolio and ensuring proper risk

management

As said in the previous chapter, the Top Down approach does not end
once each of the above three stages are complete. In fact, once a trader
has purchased and created a portfolio of stocks, just half of the work is
complete. The other half is to repeat each of the previous three stages, as
follows:

Regularly monitor the overall markets (global as well as domestic,

broader as well as sectoral, on absolute as well as relative charts). If
there is a material change in market conditions, you may need to
make changes to your portfolio to reflect those changes. For
instance, if markets are moving into a defensive mode from a risk-on
mode, you may need to increase allocation to defensive stocks and
sectors.

Constantly monitor the ratio charts of one market (such as Midcap

and Smallcap) versus the benchmark (Nifty) or one sector versus the
benchmark. This would help in tracking the relative trends and
make changes in the composition of the portfolio when there is a
material change in relative trends (such as break of an important
trend line, support, or resistance etc).

Closely monitor the price trends of stocks in which capital has been
deployed and strictly adhere to risk management principles. If a
position gets stopped out, exit without a second thought, and add a
new stock in its place that meets your screening and selection
criteria.

Keep scanning stocks from within your universe to identify stocks

that are gaining strength, both individually and relatively. If
necessary, you may even remove an existing stock from your
portfolio that is constantly underperforming the markets and add a
new one in its place that is showing greater strength and
momentum or has given an important breakout.

As an example, look at the two charts below:

If you recollect, in Stage 2, we saw Pharma as one of the four sectors that
were leading the markets higher and accordingly chose to allocate a
certain percent of the total capital to pharma stocks. However, see above
that the Pharma outperformance relative to Nifty lasted only till May
2020. Between June and September 2020, see that pharma performed
roughly at par with Nifty. However, from October 2020, see that Pharma
started underperforming Nifty. On the other hand, now look at the other
chart depicting Nifty Financial services index. After months of
underperformance, see that the financial services sector finally caught up
and started outperforming Nifty from October 2020.

With Pharma starting to underperform from October and the financial

sector starting to outperform from the same period, a trader could have
rotated out of Pharma stocks and moved into financial services stocks.
This is how you rotate your capital from sectors that are
underperforming to those that are outperforming. This is a part of Stage
4, wherein you will actively reshuffle your portfolio as and when the need
arises.

Let us conclude the chapter by showing a flow chart of the Top Down
Approach, using Technical Analysis as a primary decision-making tool.

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