Over the previous six chapters, we studied six important correlations between four tradeable asset classes namely Currencies, Commodities, Bonds, and Stocks. These included the correlations between:Over the previous six chapters, we studied six important correlations between four tradeable asset classes namely Currencies, Commodities, Bonds, and Stocks. These included the correlations between:
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Currencies and Commodities
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Commodities and Bonds
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Bonds and Stocks
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Stocks and Commodities
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Currencies and Bonds
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Currencies and Stocks.
In this brief chapter, we shall re-highlight the correlations that we have studied in the previous six chapters. Note that there is nothing new in this chapter, but just what we have said so far. In fact, this chapter can act as a quick reference guide whenever someone wants to refer back to the correlations that we have discussed in this module. So, let us get started.
Currencies and Commodities
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There is an inverse correlation between the dollar and commodities
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As the dollar strengthens, all else constant, demand for commodities from holders of foreign currency can be expected to weaken. As a result, rising dollar is bearish for commodities
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As the dollar weakens, all else constant, demand for commodities from holders of foreign currency can be expected to pick up. As a result, falling dollar is bullish for commodities
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In the late expansionary stage of a business cycle, commodity uptrend tends to accelerate, which coupled with an overheating economy raises interest rate hike expectations from the Fed. This in turn can cause the dollar to strengthen
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In the mid-to-late contractionary stage of a business cycle, commodity price downtrend tends to accelerate, which coupled with deceleration in economic activity raises interest rate cut expectations from the Fed. This in turn can cause the dollar to weaken
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A rising dollar, as it tends to exert downward pressure on commodity prices, is disinflationary
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A falling dollar, as it tends to exert upward pressure on commodity prices, is inflationary
Commodities and Bonds
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Because a steady rise in commodity prices is inflationary, periods when commodity prices are steadily climbing are usually accompanied by rising interest rates
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Because a steady decline in commodity prices is disinflationary/deflationary, periods when commodity prices are steadily declining are usually accompanied by falling interest rates
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There is a direct correlation between commodities and bond yields
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If steadily rising commodity prices fuel inflationary pressures, bond yields tend to rise
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If steadily falling commodity prices fuel disinflationary/deflationary pressures, bond yields tend to drop
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There is a strong positive correlation between copper and bond yields
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There is a negative correlation between gold and bond yields
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Gold and real yields share a strong negative correlation
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Crude oil strongly influences the trajectory of inflation, both directly and indirectly
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There is a positive correlation between crude oil and bond yields
Bonds and Stocks
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From a secular/long-term perspective, there is an inverse correlation between interest rates and stocks
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From medium-term perspective however, there could be periods when interest rates and stocks move in tandem depending on factors such as the state of the economy, the level of inflation, the positioning of the economy within the business cycle etc.
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From a secular/long-term perspective, there is an inverse correlation between bond yields and stocks
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From short-term to medium-term perspective however, there could be periods when bond yields and stocks move in tandem
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The correlation between bond yields and stocks has varied over the years. At times, the two tend to be positively correlated; while at other times, the two tend to be negatively correlated
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It is because of this that one needs to keep a close track of the correlation between bonds yields and stocks from time to time
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From 1998 to 2011, the traditional inverse correlation between bonds yields and stocks decoupled and the two moved in tandem
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Since 2011, the correlation between bond yields and stocks has varied in a way that rising yields have benefited stocks but falling yields haven’t had much of an impact on stocks. In fact, during periods when yields have declined, volatility in stock markets has shot up
Stocks and Commodities
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Stocks and commodities move in sync most of the times
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In a reviving/strengthening economy (i.e. between the late-contractionary stage till the time the economy peaks out), stocks and commodities tend to rise most of the time (with intermittent corrections in between)
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In a weakening/contracting economy (i.e. between the late-expansionary stage till the time the economy bottoms out), stocks and commodities tend to fall most of the time (with intermittent recoveries in between)
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Between the time the economy peaks out and enters the late-expansionary stage, stocks and commodities tend to decouple, with stocks starting to decline while commodities continue to rally, before eventually topping out and joining stocks lower
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Between the time the economy bottoms out and enters the late-contractionary stage, stocks and commodities tend to decouple, with stocks starting to rally while commodities continue to fall, before eventually bottoming out and joining stocks higher
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From 1994 to 2011, the traditional correlation between commodities and stocks held strongly
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Between 2011 and 2019, commodities and stocks moved in the opposite direction, with commodities falling due to strengthening dollar & weakening Chinese economy and equities rising due to ultra-low interest rates
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Since early-2020, the traditional correlation between commodities and stocks seems to have resumed
Currencies and Bonds
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The correlation between the dollar and US yields is quite dynamic and depends upon the factors that are causing the yields to move
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If movements are being driven by prevailing risk flows, US yields and the dollar tend to move in the opposite direction
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On the other hand, if movements are being driven by interest rate expectations, US yields and the dollar tend to move in the same direction
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As the Euro occupies a bulk of the weight in the DXY, the trend of the DXY is not only impacted by US yields but also by German yields
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A rising US-German yield spread is bullish for the DXY, as it makes US bonds more attractive over German bunds, causing more money to move into the US
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A falling US-German yield spread is bearish for the DXY, as it makes German bunds more attractive over US bonds, causing more money to move into Euro zone
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One can use the spread between bond yields of two countries to analyse the impact on the currency pair of those two countries
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In fact, the yield spread between two countries often acts as a leading indicator for the currency pair of those two countries
Currencies and Stocks
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Since the late-1990s, the DXY and US stock markets have mostly shared a negative correlation
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The US currency typically tends to rally during periods of global economic turmoil and decline during periods of global economic strength
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Emerging markets tend to be more sensitive to the trajectory of the dollar than developed markets
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Emerging markets are also extremely sensitive to trends in commodities and usually move in tandem with commodities
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A rising DXY hurts emerging markets more than it hurts the US or other developed markets, and vice versa
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Since 2010, developed markets have massively outperformed emerging markets because of factors such as weakening Chinese economy, softening commodity prices, strengthening dollar, and turmoil in a few emerging market economies