Technically Speaking, June 2009

Foreign currency traders worldwide need to understand that today’s financial markets are globally intertwined and should not be examined in isolation from one another.

Even novice traders know that a development affecting one market or financial sector is likely to spill over and have repercussions in other markets, because no market, particularly the forex market (which is at the center of global commerce), functions in isolation today.

But a serious disconnect still prevails between the reality of how the markets interact and the historical emphasis of technical analysis to look internally at one market at a time. Technical analysis, in this regard, has failed to keep pace with the globalization of financial markets and the emergence of the global financial system.

Changes that began in the 1980s with the proliferation of personal computers and global telecommunications—which accelerated in the 1990s with the growth of the Internet and gained momentum in this decade with the cross-border consolidation of financial exchanges worldwide—have hastened the inter-connectedness of global financial markets. Now traders need to pay very serious attention to what’s happening in other markets, even those seemingly unrelated to the markets they trade.

Still, too many individual traders, particularly newcomers just learning the ABCs of technical analysis and the mechanics of forex trading, rely solely on single-market technical analysis strategies that have been around, in one form or another, since the 1970s, but which have become obsolete in today’s environment. This narrow approach to technical analysis predates the emergence of market globalization. As a result, I believe a large percentage of these traders fail in their trading endeavors and end up losing their trading capital after a brief stint in the markets. Admittedly, traders still need to analyze the past price behavior of each individual market. If for no other reason, doing so continues to be worthwhile to identify the double tops, broken trendlines or moving average crossovers that other traders are observing, because such single-market indicators are part of the mass psychology that helps drive price action. But that narrow focus does not go far enough any longer.

It became increasingly clear to me in the mid-1980s, as the global economy was just beginning to coalesce, that intermarket analysis would become essential to traders who wanted to get an early reading on price direction in a target market before it became apparent to others. Since then, I have spoken out in numerous articles, books and television interviews that traders must incorporate intermarket analysis into their trading strategies.

Now at this juncture, as players, both big and small, shift their emphasis from one crisis to the next on almost a daily basis, amid increasing market volatility and frequent government intervention, I doubt that anyone would question the need for an intermarket perspective in their trading. If individual traders are to survive and prosper, following the wreckage of former Wall Street titans engulfed in the current financial crisis, brought on by lax lending standards, the massive securitization of mortgages, the proliferation of derivatives, and well-deserved fears related to counterparty risk, traders must open their eyes and recognize that continued reliance on single-market analysis is tantamount to financial suicide.

A Golden Oldie

Intermarket analysis has a long history in the equity, agricultural commodity and currency markets. Equity traders for years have compared returns between small- and large caps, one market sector versus another, a sector against a broad market index, one stock against another, international versus domestic stocks, etc. Fund managers talk about diversification and asset allocation as they try to achieve superior portfolio performance. Whether they are speculating for profits or arbitraging to take advantage of temporary price discrepancies, intermarket analysis in this sense has been part of equity trading for a long time.

Likewise, commodity traders have practiced intermarket analysis for decades. Farmers have been involved in it, although they may not have thought of what they do in those terms. When farmers calculate what to plant in fields where they have several crop choices—between corn and soybeans, for example—they typically consider current or anticipated prices of each crop, the size of the yield they can expect from each and the cost of production in making their decisions. Farmers do not look at one market in isolation but know that what they decide for one crop will likely have a bearing on the price of the other, keeping the price ratio between the two crops somewhat in line on a historical basis.

Currency traders and banks have also performed intermarket analysis while trading currency spreads (involving a long position in one currency and a short position in another) long before the term “forex pairs” became popular among individual traders.

The Domino Effect

The commodity markets, such as crude oil and gold, have a tremendous effect on other financial markets—including U.S. Treasury notes and bonds, which, in turn, have a powerful impact on the global equity, debt and derivatives markets. They subsequently affect the U.S. dollar and forex markets, which then further influence prices of commodities.

This domino effect, when set off by what might appear to be a seemingly isolated or relatively small triggering event at the onset, can ripple through global financial markets in a circular, cause-and-effect, dynamic process that seems to take on a life of its own. Underlying this process are inflationary expectations, changes and differentials in interest rates in different countries, counterparty risk assessment, corporate earnings growth rates, stock prices, and forex fluctuations—not to mention hurricanes and terrorist attacks—to name just a few of the potential triggering mechanisms that can set this process into motion.

Today, one can hardly name a market that is not affected by related markets or does not influence others in turn. That’s because “hot money” on a global basis—in what seems like nanoseconds—can now migrate to those markets promising higher returns or less risk. This is especially true in the foreign exchange market where a participant is always trading one currency against another. This search for returns is evident in the establishing and unraveling of so-called carry trades in recent years, as sophisticated traders and hedge funds borrowed money in low-interest-rate countries, such as Japan, and invested these funds in instruments in countries with higher interest rates, including New Zealand and Australia.

This dynamic has already played itself out a number of times since the 1987 crash, including the 1997 Asian currency crisis, the 1998 Long Term Capital Management debacle and the crisis following the 2001 terrorist attack on the United States. Each occurrence underscored the far-reaching implications regarding the fragile stability of the global financial system, itself, amid the ever-present prospect of a worldwide Category 5 financial meltdown.

As problems in the U.S. subprime credit markets spilled over into international hedge funds and banks in the summer of 2007, stock prices tumbled and traders unwound their carry trades, buying the Japanese yen and selling the higher interest rate currencies to raise cash to provide liquidity for their funds. Once started, the move fed on itself, affecting numerous global markets including forex. Within a span of less than a month, the Japanese yen went from a “weak” currency to 14-year highs against the U.S. dollar, and the Australian dollar/yen pair plunged from above 107 yen to 86 yen (see Figure 1). As the situation changed and stocks rallied to a peak in October, 2007, the pair hit the high mark again, then fell back, then rallied and then plunged again in July 2008, the large fluctuations illustrating the enormous trading opportunities and the potential profits that can be made in the forex market beyond pairs tied to the U.S. dollar.

Figure 1Source: VantagePoint Intermarket Analysis Software

As the ramifications of the subprime mortgage debacle and other problems related to debt instruments brought new revelations to traders, global forex markets responded quickly, adjusting to developments in these other markets, as the sharp plunges and rallies in this AUD/JPY pair illustrate.

The recent crisis in the U.S. credit markets and the subsequent fallout affecting highly leveraged funds illustrates again the extent to which the global financial markets are interconnected. Within hours, the reverberations from brokerage firm and hedge fund implosions tied to hybrid debt instruments and esoteric derivatives, spread to investment banks and other financial institutions around the globe, prompting central banks in the United States, Japan, Europe and elsewhere to inject funds into their own economies to provide liquidity in the hope of preventing the financial contagion from spreading farther and becoming even more severe.

As is often the case, traders’ flight to quality in a financial crisis lifted U.S. Treasuries and the U.S. dollar, which again steered away (at least temporarily) from the edge of collapse as many market pundits had been prognosticating for some time. The verdict is still out on whether or not the infusions of liquidity into the financial system and enormous capital investments by the Fed into such behemoths as Freddie Mac, Fannie Mae and AIG can actually stave off a worldwide financial system meltdown or just put off the inevitable.

The answer depends on how many other “ticking time bombs” still lurk within the labyrinth that comprises the U.S. mortgage and real estate markets. But the key point for FX traders from all of this is that they need to pay closer attention to what’s going on beyond the forex market and be on the lookout for a spark that could ignite elsewhere, and then quickly flame reactions across the globe that impact the currency markets.

Taking the Next Step

While it is important to realize that the financial markets are interdependent, it takes more than that alone to be successful as a forex trader. To turn this awareness into trading profits, traders have to be able to quantify these market interrelationships and then apply that information to actual trading situations in a way that measurably improves performance. This challenge has been the focus of my research for the past 20 years, as I have sought ways to analyze how global financial markets interact with, and influence, each other, quantify their interconnectedness and develop predictive technical indicators and methods by which traders can put this information to practical use.

For instance, if a trader wants to judge the value of the euro versus the U.S. dollar (EUR/USD), he or she not only has to look at euro data but also at numerous related markets to see how they influence the EUR/USD pair. This includes other currency pairs, as you might expect, but also U.S. Treasury notes and bonds, as well as other markets that, at first glance, may not seem to have much of a connection to the currency pair.

Often the correlation between other markets and the dollar is inverse, especially for markets such as gold or oil that are priced in U.S. dollars in international trade. When the value of the U.S. dollar declines, foreign currencies naturally rise by varying degrees, and prices for gold, oil and many other commodities usually do, too. 

As the value of the U.S. dollar weakened several years ago, the Organization of Petroleum Exporting Countries began pricing some of their crude oil exports in euros to make up for losses from the cheaper dollar. When the U.S. Dollar Index sagged to its historic lows, around 71, there was more talk from Russia about pricing its oil in euros, and several countries have announced plans to shift some of their currency reserves from the dollar into other currencies. Traders in many markets, not just forex, need to keep an eye on whether the dollar will be able to maintain its reserve currency status, as well as consider the broader implications if the dollar’s role diminishes in global financial markets.

In the future, another major challenge for FX traders will involve China’s response to U.S. pressure to revalue the Chinese yuan. Any movement will likely continue to be slow and calculated to preclude any severe disruptions to Chinese and world markets, but this is a development that currency traders and others need to monitor closely for the potential jolt it could have on numerous global financial markets, particularly forex. It’s unlikely that a trader will know exactly when and how any adjustments might unfold, but intermarket analysis can provide some early clues for those markets that he or she trades.

Analytical Challenge

As the recent market turmoil and financial crisis has highlighted, many traders still ignore intermarket analysis altogether or fail to implement it in an effective way as part of their trading plans. At best, traders too often rely upon simplistic ways to evaluate and compare markets. The complexity of the dynamics behind market movements, which I call ‘market synergy’, and how markets influence each other demonstrates that just comparing price charts of two currencies and looking at the spread difference or a ratio between their prices (to measure the degree to which they move in relation to one another) is totally inadequate in today’s highly volatile, global trading environment.

This approach is too limited because it does not take into account the influences exerted by other currencies or
other related markets. Additionally, such correlation studies fail to address the often changing leads and lags that
exist in the global economy as they affect market dynamics.

Introducing Intermarket Data

Intermarket analysis provides a more comprehensive set of data points for analysis than simply looking at an individual market’s past prices. Through the use of a sophisticated artificial intelligence tool called neural networks, which I first started working with in the late 1980s, both single-market data from a particular target market, such as one of the forex pairs, and intermarket data from perhaps dozens of related markets are used as inputs into the neural networks. Once the networks have been properly designed, trained and tested, they can be used in real-time trading with current market data updated each day to produce highly accurate, short-term forecasts for the target market.

Knowing that it would be futile to attempt to make accurate long-term forecasts (just like it is impossible to do with weather forecasts of the path of a hurricane), the neural networks are designed to make predictions for just one or two days into the future. Of course, even for this short timeframe, it is folly to expect perfectly accurate forecasts. That’s not only unrealistic, it’s simply impossible due to inherent randomness in the markets and unforeseen events that affect them.

No ‘Holy Grail’

The good news is that traders only need to tilt the odds in their favor through access to reasonably consistent and accurate short-term forecasts. With powerful analytical tools such as neural networks that use intermarket data from related forex and other global markets, popular technical indicators such as moving averages and moving average convergence divergence, among others, can be transformed from single-market lagging indicators into powerful intermarket-based leading indicators (see Figure 2).

Figure 2Source: VantagePoint Intermarket Analysis Software

Data provided by intermarket analysis can be used to forecast short-term (red line) and medium-term (blue line) moving averages that often lead turns in the actual medium-term moving average (black line), sometimes by several days, as the arrows at the major turns illustrate. 

With predictive information available to traders through use of leading indicators, traders can gain needed confidence and have the necessary discipline to adhere to their trading strategies, so that at the right time they can pull the trigger without self-doubt or hesitation while everyone else is becoming paralyzed with fear. In today’s fast-paced forex market with the possibility of a Category 5 worldwide financial meltdown looming on the horizon, this can be the difference between becoming one of the privileged few or sinking backwards down the socio-economic ladder. For the millions of baby boomers, facing retirement just around the corner, these alternatives are worlds apart. It’s simple; in the 21st century, information is power.