8/7/2019 b52731bc-c841-4c3d-a45b-4eae504ca08a

1/6

CURRENCY TRADING

Intermarket Analysis

of Forex Markets

LOUIS B. MENDELSOHN

40 MARCH 2008

8/7/2019 b52731bc-c841-4c3d-a45b-4eae504ca08a

2/6

You are probably familiar with equities traders who compare re-turns between small-caps and big-caps, one market sector versusanother, a sector against a broad market index, one stock againstanother, international stocks versus domestic stocks. Portfoliomanagers talk about diversication as they try to achieve thebest performance. Whether they are speculating for prots orarbitraging to take advantage of temporary price discrepancies,intermarket analysis in this sense has been part of equities trad-ing for a long time.

Traders in the commodities markets have also been into inter-market analysis for a long time, trading spreads that have a reli-able track record. Farmers have been involved in intermarketanalysis for years although they may not have thought of whatthey do in those terms. When they calculate what to plant inelds where they have several crop choices between corn andsoybeans, for example they typically consider current or an-ticipated prices of each crop, the size of the yield they can expectfrom each crop and the cost of production in making their deci-sion. ey do not look at one market in isolation but know thatwhat they decide for one crop will likely have a bearing on theprice of the other, keeping the price ratio between the two cropssomewhat in line on an historical basis.

e price relationships of corn to soybeans or hogs to cattle orgold to silver or T-bonds to T-notes have been the subject of intra-commodity and inter-commodity spread analysis and havebeen an integral part of technical analysis of the commoditiesmarkets for decades, long before John Murphy and I broughtthe term intermarket analysis into vogue.

e commodities markets, in turn, have a tremendous effect onthe nancial markets such as Treasury notes and bonds, whichhave a powerful effect on the equities markets, which have aneffect on the value of the U.S. dollar and forex markets, whichhas an effect on commodities . . . e ripple effect through allmarkets is sort of a circular cause-and-effect dynamic involvinginationary expectations, changes in interest rates, corporateearnings growth rates, stock prices, forex uctuations. You canhardly name a market that isnt affected by other markets or,in turn, doesnt affect other markets. Whatever the market, as-sets tend to migrate toward the one producing or promising thehighest return. ats as true for forex as any other market.

You have probably heard the expression, If the U.S. economy sneezes, the rest of the world catches cold or that the health of the U.S. economy is the engine that drives the global economy.It works both ways as a sneeze elsewhere in the world can have asignicant impact on U.S. markets, as was evident in the Asiannancial crisis in 1997 and other incidences over the years thathave provided proof, if any was still needed, of how linked to-days global markets are.

Most traders stress the role of fundamental informationand historical single-market price data in analyzingmarkets for the purpose of price and trend forecast-ing. Traders do need to look back at past price action to putcurrent price action in perspective, but they also need to look forward to anticipate what will happen to prices if their analysisis to pay off in the real trading world.

To be able to look ahead with condence, however, traders needto look in one other direction, and that is sideways to what ishappening in related markets, which has a major inuence onprice action in a target market. What are the external marketforces that affect the internal market dynamics the intermarketcontext or environment in which the market you are tradingexists?

Moving beyond single-market analysisIntuitively, traders know that markets are interrelated and thata development that affects one market is likely to have repercus-sions in other markets. No market is isolated in todays globalnancial system. However, technical analysis has traditionally

emphasized single-market analysis, focusing on one chart at atime and failing to keep up with structural changes that have oc-curred in nancial markets as the global economy has emergedwith advances in telecommunications and increasing interna-tionalization of business and commerce.

Many individual traders still rely upon the same types of mass-marketed, single-market analysis tools and information sourcesthat have been around since the 1970s when I rst started in thisindustry. And a large percentage of traders continue to end uplosing their trading capital. If youre still doing what the massesare doing, isnt it likely that youll end up losing your hard-earned money, too?

In the forex markets especially, you cannot ignore the broaderintermarket context affecting the market that you are trading.You still need to analyze the behavior of each individual marketto see the double tops or broken trendlines or indicator crosso-vers that so many other traders are following because thats partof the mass psychology that drives price action. However, it is in-creasingly important that you factor into your analysis the exter-nal intermarket forces that inuence each market being traded.

Historical roots

Intermarket analysis is certainly not a new development for trad-ers, having roots in both the equities and commodities markets.

Louis B. Mendelsohn is Presidentand Chief Executive O cer of Market

Technologies

4141MARCH 2008

8/7/2019 b52731bc-c841-4c3d-a45b-4eae504ca08a

3/6

CURRENCY TRADING

Intermarket analysis: The next logical stepSo, a quantitative approach to implement intermarket analysis,which has been the basis o my research since the mid-1980s,is neither a radical departure rom traditional single markettechnical analysis nor an attempt to undermine it or replace it.Intermarket analysis, in my opinion, is just the next logical de-velopmental stage in the evolution o technical analysis, giventhe global context o todays interdependent economies and -nancial markets.

Bottom line: I you want to trade orex markets today, you haveto use a trading tool or adopt an approach or trading strategy that incorporates intermarket analysis in one way or another.An important aspect o my ongoing research involves analyz-ing which markets have the most infuence on each other anddetermining the degree o infuence these markets have on oneanother.

Hurricaneomic analysis M is a per ect example o the inter-connectedness o events and markets and how nothing can be

looked at in isolation. ake the spate o hurricanes that hit theGul Coast and Florida in 2005. Tey did not simply cause lo-cal damage to the economy o those regions. On the contrary,there are hurricaneomic e ects that will ripple throughout theworld economy or months and years to come, impacting theenergy markets, agricultural markets, building materials includ-ing lumber, the ederal de cit, interest rates, and, o course, the

orex market as it pertains to the U.S. dollar. So, hurricaneomicanalysis goes hand-in-hand with intermarket analysis in lookingat events such as natural disasters and their e ects on the global

nancial markets.

Our research in the ongoing development o VantagePoint sinceits introduction in 1991 indicates that, i you want to analyzethe value o the euro versus the U.S. dollar (EUR/USD), orinstance, you not only have to look at euro data but also at thedata or these other related markets to nd hidden patterns andrelationships that infuence the EUR/USD relationship (see Fig-

ure 1):

Australian dollar/U.S. dollar (AUD/USD) Australian dollar/Japanese yen (AUD/JPY) British pound Euro/Canadian dollar (EUR/CAD) Gold Nasdaq 100 Index British pound/Japanese yen (GBP/JPY) British pound/U.S. dollar (GBP/USD) Japanese yen

Figure 1 Related MarketsWhen you are trading the USD/JPY orex pair, you need to takeinto account another set o intermarket relationships includingthe ollowing markets:

5-year U.S. reasury notes Euro/Japanese yen (EUR/JPY) Gold Euro/Canadian dollar (EUR/CAD)

MARCH 200842

8/7/2019 b52731bc-c841-4c3d-a45b-4eae504ca08a

4/6

Euro/U.S. dollar (EUR/USD) British pound/Swiss ranc (GBP/CHF) Crude oil Nikkei 225 stock average S&P 500 Index

Many market inter-relationships are obvious, but others may seem more distant and unrelated, such as the importance o

stock indices, U.S. -notes or crude oil prices on pricing o theUSD/JPY orex pair. Research has veri ed that these relatedmarkets do have an important infuence on a target orex mar-ket and can provide early insights into the orex markets utureprice direction.

Additionally, through hurricaneomic analysis, data related toevents such as the recent natural disasters in the U.S. can also beincorporated into orecasting models, along with single-market,intermarket, and undamental data. Tis results in an analyticparadigm that I call Synergistic Market Analysis M

Gold and oil and forex

In some cases, the correlation is inverse, especially or marketssuch as gold or oil that are priced in U.S. dollars in interna-tional trade. I you look at a chart comparing the price o goldand the value o the U.S. dollar (see Figure 2), you will see thatwhen the U.S. dollar declines, not only do oreign currencies risebut gold prices also rise. Studies on data rom the last ew yearshave shown a negative correlation between gold and the dollaro more than minus 0.90 that is, they almost never move intandem but almost always move in opposite directions.

Figure 2 Gold and the US DollarTe value o EUR/USD versus gold prices, on the other hand,

shows a high positive correlation that is the value o the euroand gold prices o ten go hand in hand, suggesting these marketsare both bene ciaries when unds are fowing away rom theU.S. dollar (see Figure 3).

Figure 3 Gold and the Euro

So gold prices are an important component in per orming inter-market analysis o the orex market. I you see a trend or pricesignal on a gold chart, it may be a good clue or taking a positionin the orex market, where a price move may not have started tooccur yet. Or vice versa: A orex move may tip o a gold move.

One o the actors cited or the rise in oil prices is the weak-ness o the dollar as oreign oil producers viewed increases inoil prices as a way to maintain their purchasing power in U.S.dollar terms (see Figure 4). One way to counter the impact o higher oil prices is a weaker dollar, in what could become a vi-cious infationary cycle.

Figure 4 Oil and the US DollarOil is a key commodity driving global economic growth, and oilprices and orex have a key relationship in the global economy.For example, when oil becomes expensive it hurts the economy o Japan, which has to rely on imports or most o its energy needs. Tat weakens the yen. High oil prices bene t the econo-my o a country such as the United Kingdom, which producesoil. Tat strengthens the value o the British pound.

Because o oils standing in world business and commerce, any-

thing that a ects its supply or distribution is likely to producea response in the orex market. Tats why terrorist attacks ornatural disasters such as hurricane Katrina, which threaten the

4343MARCH 2008

8/7/2019 b52731bc-c841-4c3d-a45b-4eae504ca08a

5/6

8/7/2019 b52731bc-c841-4c3d-a45b-4eae504ca08a

6/6

shi ts in the orex market, especially with China as a major play-er in cotton because o its textile industry. Forex traders worriedabout the impact o Chinas revaluation o its currency on theworlds orex market might even think about trading in the cot-ton market.

Te amount o infuence that one market will have on anothermarket will naturally shi t over time so these relationships arenot static but should be the subject o ongoing study. Forex trad-ers should also be aware that the impact rom related marketsmay not be instantaneous. It may take some time or a policy decision or other development to have an impact on the ever-changing marketplace, or an infuencing condition may havea bearing on market direction or only a short time, meaningtraders may have only a brie window in which to capitalize ona trading opportunity.

Analytical challengeIntermarket analysis is not an easy task to accomplish or theaverage orex trader. Te complexity o the dynamics betweenmarkets and their infuences on each other mean that just com-paring price charts o two currencies and producing a chart o the spread di erence or a ratio between the two prices is notenough to get the ull picture o a currencys strength or weak-ness or its potential or a price move.

Some analysts like to do correlation studies o two related mar-kets, which measures the degree to which the prices o one mar-ket move in relation to the prices o the second market. womarkets are considered per ectly correlated i the price changeo the second market can be orecasted precisely rom the pricechange o the rst market. A per ectly positive correlation oc-curs when both markets move in the same direction. A per ectly negative correlation occurs when the two markets move in op-posite directions.

But this approach has its limitations because it compares priceso only two currencies to one another and does not take into ac-count the infuence exerted by other currencies or other marketson the target market. In the nancial markets and especially the

orex markets, a number o related markets need to be includedin the analysis rather than assuming that there is a one-to-onecause-e ect relationship between just two markets.

Nor do the correlation studies take into account the leads andlags that may exist in economic activity or other actors a ecting

a orex market. ypically their calculations are based only onthe values at the moment and may not consider the longer-termconsequences o central bank intervention or a policy changethat takes some time to play itsel out in the markets.

Te Canadian and Australian dollars, or example, are consid-ered to be commodity currencies. Tey may be highly corre-lated when some development infuences raw commodity pricesin general, and they may move in tandem as the value o theU.S. dollar or other major currencies move in the other directionby varying amounts.

But the Australian dollar is more sensitive to developments in

Asia and may be more responsive to what is happening in thatarea o the world, at least or a while. Likewise, as Chinas cur-

rency becomes more signi cant in world currency markets, itmay have more infuence on the Japanese yen than on othermajor currencies. Or developments in the British economy may keep the British pound rom ollowing the lead o the euro.

Multi-market efect

Te orex market is a dynamic marketplace, constantly shi t-ing and evolving. It is not one currency versus the world butall currencies a ecting all other currencies to a greater or lesserdegree. When you try to examine the multiple e ects o veor ten related markets such as orex simultaneously on a targetmarket going back on ve or ten years o data to nd recurring,predictive patterns, methods such as linear correlation analysisand subjective chart analysis quickly reveal their limitations andinadequacies as trend and price orecasting tools.

Forex market inter-relationships can not be erreted out withsingle-market analysis tools. I you are serious about orex trad-ing, you need to make the commitment to get the right tools

rom the get go, or you are likely to struggle to keep your ac-count intact. Since we are talking currencies here, we might in-terject another amiliar saying: Penny wise and pound oolishwhen it comes to investing in analytical tools.

O course, no matter what you spend or what tools you use,nothing is 100% correct. Even the best tool can only give youmathematical probabilities, not certainties. But your tools dontneed to be per ect to give you a trading edge.

I you have analytical tools that can nd and identi y the re-curring patterns within individual orex markets and betweenrelated global markets, youve got all you need to have a leg upon other traders. Tis insight into price activity over the next ew days can give you added con dence and discipline to adhere toyour trading strategies and enable you to pull the trigger at theright time without sel -doubt or hesitation.

Louis B. Mendelsohn is President and Chie Executive Ofcer o Technologies. Mr. Mendelsohn began trading equities in the early 19

ollowed by stock options. Then, in the late 1970s he started tracommodities, as both a day and position trader. In 1979, he ormMarket Technologies to develop technical analysis trading so twarthe commodity utures markets.

In 1983, Mr. Mendelsohn pioneered the rst commercial strategy btesting and optimization trading so tware or microcomputers. Bymid-1980s these capabilities had become the standard in microcomputrading so tware or both equities and utures, ueling the growtodays multi-million dollar technical analysis so tware industry.

Recognizing the emerging trend toward globalization o the wornancial markets, in 1986 Mr. Mendelsohn again broke new groun

technical analysis when he developed the rst commercial intermaranalysis so tware in the nancial industry or microcomputers. Buon his extensive research in the 1980s involving intermarket analin 1991 Mr. Mendelsohn released VantagePoint Intermarket AnaSo tware, which makes short term market orecasts based upon pattern recognition capabilities o neural networks.

4545MARCH 2008