In the forex market, a large bank who wants to trade in US dollars can do so in a multitude of ways. First, the bank could simply sell Euros to buy US dollars, a straightforward sell on the EUR/USD. But, if the trade size were significant, the bank may decide to sell against another currency, the EUR/GBP for example, and then to sell the GBP against the USD. This achieves the same result, but hides the true nature of the buying and selling from view. This is what makes the forex market both unique and complex, and why trading using one chart and one time frame can be dangerous.
"The market is designed to fool most of the people most of the time."
— Jesse Livermore
The old trading methodologies and approaches no longer work. For example, the currency markets are no longer driven simply by interest rate differentials. They are now highly politicized and manipulated as individual countries attempt to protect their own export markets by competitive devaluation. Moreover, quantitative easing has now entered the trading lexicon, with central banks happily printing money, further distorting the financial markets. To succeed as a trader now requires a much deeper understanding of market behavior, of market sentiment, of money flow, and risk appetite, which can be achieved using a trilateral approach:
- relational (intermarket analysis)
- fundamental
- technical
These are the three strands of market analysis which when combined, provide the three dimensional view of the market, which so few forex traders use. Without it, failure awaits. With it, trading becomes stress free, as each trading opportunity is based on a complete view of the market, the money flow, and consequent risk.
Markets move on risk and sentiment, which is then reflected in the consequent flow of money. No market trades in isolation, and all markets are inter connected via a variety of linkages. These linkages exist in all timeframes and can be seen on every price chart, and can be used by all types of traders, whether as an intraday scalper, or a longer term swing or trend trader.
Bonds
Bonds are generally considered to be a safe haven asset, and are the basic ingredient of the world's debt capital markets, which in turn are the cornerstone of the world's economy. Bonds are very simple to understand. They are simply a loan. Nothing more, nothing less. We all borrow money in a variety of different ways, and the bond market is structured in such a way as to allow all sorts of bodies, including countries, governments, municipal authorities and private companies, to borrow money for a variety of reasons.
This then leads to the next question, which is why do companies and governments buy and sell bonds, and what do they tell us about the money flow, and this is where we return to the word risk. Bonds are generally perceived as a low risk investment. Therefore, if the money flow is into bonds, and away from other markets, then clearly investors and speculators are nervous, and looking for a safer haven for their money. So, in general terms, bonds are a low risk asset class which will normally see inflows of money when markets are nervous. In addition, they are also the ultimate barometer of interest rates, inflation, public sector debt and economic growth, all key measures of the flow of money and currency exchange rates as a result.
But how do we analyse this huge market to help us in our trading? The answer is yield. This simple measure gives us all the clues and signals of market sentiment, risk appetite and consequent money flow. Yield tells us whether the market is buying or selling bonds and whether the yield is therefore rising or falling. Put this on a chart and you have all your analysis for bond markets, in exactly the same way as for any other instrument.
Commodities
The relationship between bonds and commodities is one of the pivotal relationships in the financial markets. If bonds are purely about money and the cost of money, the commodities markets are where real money is exchanged for real goods bought by real people to make real goods. In other words, the commodity markets play the central role of converting money into raw materials and in doing so, gives us a clear insight into the fundamentals of world economics.
This relationship is the bridge between the speculative world of paper based assets and the tangible world of real goods. It is the commodity markets that provide the pivotal insights into central bank policies, global economic growth and decline, currency flows and investor sentiment. A real world view where prices are largely dictated by supply and demand across continents.
While commodity markets provide the real world bridge between money and goods, those same commodities, then in turn provide a bridge between commodities and individual currencies. A commodity based economy will sell its raw assets overseas in return for hard currency, which in turn is likely to be reflected in the currency itself.
Conversely, of course, an economy lacking in base commodities will need to import to maintain economic growth. A country such as Japan for example, has to import virtually all the base commodities such as oil, gas, and metals, a fact which is often seen in the CAD/JPY pair, which correlates relatively closely to crude oil.
Equities
Just like bonds and commodities, equities tell us a great deal, not least about risk appetite and market sentiment and, as you would expect, there is a strong relationship between equities and bonds. After all, equities are viewed as high risk, offering higher returns, whilst bonds are considered to be low risk with conservative returns.
As a result, there is a continuos flow of money between these two markets, with a consequent and related flow, both in and out of particular currencies and currency pairs. Equity markets therefore provide us with a barometer of market sentiment, which in turn is reflected in the broader economy, and associated markets such as commodities.
A further facet to the relationship between currencies and equities is from an investing perspective. The best example of this is the relative strength of the Japanese yen and consequent flow into and out of the Nikkei 225. A weak yen usually results in inflows into Japanese shares from overseas investors, looking for better returns. This is a classic example of the linkages and relationships which exist at all levels and across the four capital markets, but which are rarely considered by most traders, or even investors.
Currencies
Currencies is the axis around which all the other markets revolve. Why? Because it is purely concerned with money and, as such, is the most liquid of all the markets. Currencies can be converted instantly—the flow is instant and immediate, allowing market participants to change direction in a flash, as risk sentiment changes on market news or economic data. Every decision in every market, whether as an investor, speculator, government, bank or institution is about money, risk and return, which is why the forex market is the hub around which all the others rotate.
Second, the forex market is more complex than all the above mentioned markets. Why? Because it is the market in which the central banks, governments and politicians all manipulate their home currency in one way or another, either for economic or political reasons. This is the market where global politics meets money in one glorious melting pot. It is also the primary market which offers central banks a small degree of control over the economic landscape as the international powers battle for supremacy. Ever since 2008, with the start of the financial meltdown, the rules have changed dramatically. No longer do currencies trade on simple interest rate differentials driven by inflation, growth and economic data. Now protectionist policies, market manipulation and artificial stimulus are all part of the mix.
Third, it is the only market where buying or selling of an instrument can take place against several other instruments. As mentioned at the outset, a bank or large hedge fund wishing to sell the US dollar can do so against a raft of other currencies using a variety of mechanisms to achieve this end. Indeed, they will often do this, in order to mask their activities by constructing complex trading and hedging strategies.
