Sunday, April 6, 2008

Of Inflation,Interest Rates And Inter Market Relationships !!!

I confess, up till now, whenever we had talks about Inflation, Interest Rates and Inter-Market Relationships, my reaction was like many others, just give the figures a quick glance (couldn’t help, you see, because my knowledge was absolute zilch!!!). This weekend was dedicated to do some serious reading, and try to simplify things for my self. Inflation, I still don’t understand (may be never will, there are certain things, the government doesn’t want you to understand….what the heck they themselves don’t understand!!!). I remember a few months back during the bull frenzy, every Friday we celebrated Inflation figures. The way they were decreasing, I started to think, maybe we might hit 0% (wishful thinking!). Well during that time when Inflation was almost 4%, things weren’t cheaper than they are now, with Inflation touching 7%. I am still clueless; I guess its better left to the learned people.

Anyway Inflation leads to Interest Rates.

Let us see how the change in Interest Rates affects the stock market:

  • Any change in price charged for credit, has an effect on levels of economic activity and therefore on the corporate profits indirectly.
  • Since change in Interest Rates affects the bottom-line, therefore the levels of rates have a direct affect on corporate profits.
  • Movements in Interest Rates alter the relationship between bonds and equities, two primary competing financial assets.
  • Most of the stocks are purchased on margin (debt). Any change in cost of carrying that debt will influence the investors to maintain these margined positions.

According to Martin.J.Pring “It’s not the levels of rates that is important, but their rate of change, because this has bigger influence on profits & equity prices”.

Discount Rates: Movement in Discount Rates, reflect changes in monetary policy & are therefore of key importance to the trend of both the short term interest rate & equity prices. Reversal in the trend of Discount Rate implies that the trend in market interest rate is unlikely to be reversed for at least several months.

  • How Discount Rate Effects Short Term Rates

A Discount Rate cut after a series of hikes, acts as a confirmation, that a new trend of lower rates in under way

  • Effect On Stock Market

It is said, every major Bull Market peak in equities, has been preceded by a rise in Discount Rate.

There is a well known rule in Wall Street; Three Steps & a Stumble! It was developed by Edson Gould, and implies that after three consecutive rate hikes, the equity market is likely to stumble, and that it is time to enter the Bear Market.

All this leads us to Inter Market Relationships.

Early warning signs of Inflation & Interest rates are usually spotted if one does Inter Market Analysis.

Here are a few Inter Market Relationships.

  • Program Trading

There is a close link between stocks & futures & this is seen very clearly in the relationships, between S&P Cash Index & its Futures Contract. Normally the Futures Contract trades at a premium to the Cash Index. The premium is decided by short term interest rate, yield on Index & days to expiry. Each day institutions calculate, what the actual premium should be, and this is called FAIR VALUE. When premium exceeds Fair Value, this is an arbitrage trade. In such a scenario traders sell futures & buy a basket of stocks to bring both these entities in line. It’s the opposite case, when premium falls below Fair Value. Program buying is positive for the market & selling is negative

  • Link Between Bonds & Stocks

Stock market is influenced by the direction of Interest Rates. This can be monitored by tracking the Bond prices. The Bonds move in the opposite direction of Interest Rates, therefore, when Bonds are rising, Interest Rate declining, it is positive for stocks. When Bonds falling and Interest Rate rising, this is negative for stocks.

  • Link Between Bonds & Commodities

Bond prices are influenced by expectation of Inflation. Commodity prices are considered to be a leading indication of inflation. As a result Commodity & Bond prices normally travel in opposite directions.

  • Link Between Commodities & Dollar

Rising Dollar has a depressing effect on most Commodity prices, in other words rising Dollar is normally considered as non inflationary. The best example of Dollar & Commodity link is, seeing Gold & Dollar in action. It’s observed that the Dollar & Gold trend in opposite direction & Gold acts as a leading indicator for other Commodities.

So it all boils down to inter linking- gotta keep an eye on all this- Dollar affect Commodity, which in turn affect Bonds, which in turn affect Stocks.

Phew!!!!! Hard work … who said being a TA & a Trader, is an easy work. I don’t know whether all this will make me a better trader, but one thing is sure, all this will certainly make me sound intelligent (perhaps this intelligence can make some money for me finally). For all you who want to read further on the topic, can read Inter Market Analysis by John Murphy and When The Markets Moves Will You Be Ready by Peter Navarro. As for me I am going to explain my wife how we can’t buy that popcorn & cola during the movies……Inflation!!!!!


Nilesh Birani said...

Simple & Timing is perfect for the Article.....We hit 7% Inflation and article also get 7 out 10.

Tryin2Trade said...

Hi, and thanks for your appreciation.

Bulent said...

Hi, Manoj.
Good blog. Congratulations!
To me: I'm also a fan of Murphy. Less because of his technical analysis skills, more because of his intermarket analysis, which I evaluate as rather "fundamental" view of the matter, despite of use of charts to proove the validity of his thesis. So I'm regularly a "No-trader", more a long run investor!
And one objection to the sentence:
"Bond prices are influenced by expectation of Inflation. "
I assume that that the increase of the bond prices depends more to
1. the aggressiv falling FED refund rates (which generates gains in bond investments) and
2. the "safe heaven" function of US-bonds because of the credit crunch possibility and bust of financial institutions! And not because of the falling inflation rates!!! So today there is no dependence between bond prices and commodity prices! Rather the commodity consistency keeps on!
So, the question is: What happens as next when inflation stays on this high level (china and india are keep on growing, despite of US recession)and the short term US-interests are further decreasing?