Markets 101: Stocks, Bonds, Currencies and Commodities
Here's a primer on market movement
By John Lansing, Editor, Parabolic Options | Mar 4, 2013, 10:50 am EST
Technical analysis can seem very overwhelming when trying to understand the process and behavior patterns of inter-market relationships and correlations. With technology today, we have the ability to watch every currency, stock market average, commodity, and even the bond markets around the globe.
Let's simplify how commodities, bonds, currencies and stocks all interact and the consequences they have on one another.
As commodity prices rise, the cost of goods moves higher. The commodity rise increases prices, which is viewed as inflationary, so a natural response to increasing commodity prices is a rise in interest rates because the price action in commodities requires a response. That response, more often than not, is higher interest rates to keep the balance.
Now, because the correlation between rising interest rates and bond prices are inverse, bond prices fall as yields rise, which simply means higher interest rates.
Bonds and Stocks
Bond prices and stocks are, by and large, interlinked. So, when bond prices begin to decline, stocks will eventually follow suit and head down in the same direction. In short, as the cost of borrowing rises due to inflation, a reasonable assumption is stocks will decline as a result of borrowing costs. As with most inter-market relationships, we often see a lag between the "Yin and Yang," (i.e. rising rates mean bonds are falling). Stocks eventually follow and harmony is restored.
Currencies and Commodities
The fluctuating currency markets also have an effect on all markets and commodities. But the largest impact that currency moves have on any asset class is commodities themselves, as they are the primary beneficiary or, in the opposite case, the sinister target. Commodity prices also have a direct impact on bonds and, subsequently, this all spills over into the stock market - sometimes in bullish fashion and other times in bearish turmoil.
The U.S. dollar and commodity prices historically trend in opposite directions, but that in and of itself should never be a reason to buy and sell anything. As one of the first advisory services I followed said, "If you think the dollar is rising and you are bullish on the dollar, go long the dollar. Conversely, if you think gold is bearish and is going down, short gold. However, as a rule of thumb, it's never been a good idea to go long one thing because another thing is falling or vice-versa."
That said, because so many commodities are priced in U.S. dollars and not in other currencies (for example crude oil) abrupt changes in trend direction like we are seeing now in the U.S. dollar, which has been in a parabolic rise, is causing a negative price response to West Texas Crude Oil (WTIC).
The diagram below shows how each part of the market affects the others, going from left to right.
Bear in mind that the impact lags between how each of the markets react to the sudden fluctuations that start from the left and move to the right. Not everything happens instantly and during those transitions or response lags other factors could come into play, including intervention to divert the natural response. When that happens, think of it as nothing more than an attempt that simply delays and creates a larger lag in the "Yin and Yang" merely to disrupt the natural order in hopes of achieving some pseudo realignment. It never works, but human nature is to think it will "this time around."
Fed Fiddling with the Balance of the Market
Now, let's talk about what I am seeing, which is the opposite of what I have discussed so far. I'm seeing a deflationary environment.
I'd describe deflation as good for nothing because when it comes to the stock market, just about everything goes down. With huge swings in the currency market pushing commodities lower, especially at the current speed, the potential for growth is limited when we have conditions that can only be described as the "perfect storm."
When the falling prices of deflation last long enough, they create a vicious cycle of some or all of these negatives.
Reduction in the supply of money or credit, harder to get a loan
Decrease in government, personal or investment spending
Increased unemployment since there is a lower level of demand in the economy
Falling corporate profits, which can lead to the closing of factories
Decreasing nominal prices for goods and services
And the worst yet - it can lead to economic depression.
Finding the correct amount of inflation to offset deflation is a nightmare for central banks because they have created the largest debt bubble in history. This is why we are always hearing about the fiat money wars versus gold and other precious metals. Each time deflationary forces re-assert themselves to offset inflationary forces, the Fed has to correspond with even more aggressive forms of monetary stimulus to keep systemic failure at arm's length.
With the rise and fall within all these asset classes discussed above, it's become more important than ever to watch how all these inter-market relationships affect the next to gauge the future trend changes in stocks.