What other markets can tell you about the one you are trading

By looking at the combination of various markets, we are often able to better determine what market participants are discounting, whether it be economic activity, inflation, some political event etc.

For example, a rising currency together with a falling bond market (rising bond yields), rising stock market and rising commodities may indicate extreme confidence in economic activity as the market is utilizing the liquidity generated by the central bank (by moving from bonds to stocks) and the rising currency indicates increased capital inflows from other countries (perhaps going into the stock market).Whereas a rising currency together with a falling bond market (rising bond yields), falling stock market and rising gold may indicate that the markets are worried about inflation.

Furthermore, it must also be noted that we should treat ‘cash’ as a virtual instrument that we can ‘derive’ from the bond, stock and commodity markets. When traders exit their positions in those markets, they go into cash. This does not apply in the currency markets because your cash will always have to be denoted in some currency – you’ll be long in the currency that your trading account is held in.

Assuming that monetary policy is accommodative and the bond, stock and commodity markets all made a temporary retracement (in other words traders moved into cash), this creates a high reward, low risk scenario, as holding cash will be expensive and the additional liquidity generated by the central bank will have to flow into some market at some point. One could take advantage of such an opportunity by establishing a hedged long position in all three markets. The reverse scenario of a restrictive monetary policy and a temporary rise in those markets also holds true.

The point is that it is beneficial to study the reactions of other markets that one is not necessarily trading.