Inter-market Relationships

All too often, people look at different markets in isolation. In fact, various undergraduate investment clubs around the world even divide their clubs into sectors or industries. Structuring clubs this way is perfectly fine, but the temptation however as a sector lead analyst is to focus solely on the domestic economy. To fully maximize the investing opportunities, all geographic and asset markets must be taken into account.

Historically, there has typically been an inverse relationship between stock prices and bond prices. The reasoning was that bonds were seen as protection, and so when investors worried about falling stock prices, they would redirect their funds into safer bonds, including the so-called riskless Treasuries. And so bond yields, which move opposite to bond prices, tended to move together with stock prices. But these times are not normal. Over the past two years, we have seen are moments when stock prices rose and yields fell, simultaneously. Just between September 2008 and March 2009, we saw U.S. stock prices fall off a cliff but bond yields remain relatively stable, before a brief recovery at the end of November in stock prices and bond yields skydiving. Certainly, the Federal Reserve tinkering with interest rates certainly had a lot to do with stock and bond prices, but just tracking these two markets can already help gleam insight on investor sentiment.

Taking the currency markets into account gives a much clearer picture of what happened. The USD, tracked against a basket of currencies, strengthened considerably when the stock market, and the entire U.S. economy, looked the bleakest. At first glance, this seems counter-intuitive since holding USD is the equivalent to holding a share in the U.S. economy. But when the markets are swinging wildly, a currency investor is going to look for safer currencies, and interest rates are often used as a proxy for the safety of a currency. With an interest rate of near zero, currency investors flocked to the USD as well as the Japanese Yen.

As a materials or heavily-exporting company, watching the dollar fall is a blessing in disguise. A weak dollar translates into higher income from exports with the exchange rate. Likewise, a weaker dollar generally leads to higher commodity prices since producers can sell the commodity to other regions with stronger currencies at the same price.

Factoring in all these variables, it is pretty clear to see that the predominant model over the past year has been risk-appetite, with the stock market usually leading the charge. When the stock market moved up, investor risk-appetite increased and money flowed away from safe currencies to higher-yielding currencies like the Australian Dollar or the Brazilian Real. With bond prices, actually with so much money on the sidelines we have seen risk-appetite drive both bond and stock prices together. And so while historically, we have seen a negative relationship, right now we see a positive relationship between the two markets.

Moving forward, tracking how stocks, bonds, currencies, and commodities move is key to gaining an advantage. In panic situations, the risk-appetite has tended to be the predominant model, but should the four markets move significantly differently from what we have seen over the past year, it could be a signal that the money on the sidelines has flowed back in. When that happens, we could see markets behave more inline with their historical relationships and as an investor, it means it is time to find the new model.