The Interconnectedness of Financial Markets

Globalization is the free movement of people, goods, and services across boundaries. Due to Globalization, trade, and technology have made the world a more connected and interdependent place because of the expansion of trade, cross-border commerce, and access and engagement to financial markets and trading. While this connection has global benefits, it can also enable minor disruptions to compound into larger-scale crises.

The analysis of inter-market relationships examines the correlations between different asset classes. The correlation may be positive or negative. Financial markets tend to correlate positively or negatively with other markets. These relationships are the foundation of market dynamics.

A positive correlation exists when two variables move in the same direction. The principle of supply and demand is common in all markets. If demand is more for a commodity in the market, the price will go up, which is an example of a positive correlation. If Petrol/Diesel prices are increased, transport charges will be increased,  cost of agricultural commodities prices in the market will be increased, it is another example of a positive correlation.  Stock markets around the world are positively correlated. Strength from the Dow Jones, and S&P 500 tends to flow into the Asian markets led by Japan’s Nikkei, South Korea’s KOSPI, India’s Sensex, and Nifty 100.  Chinese market indexes Hang Seng and Hong Kong tend to fluctuate between positive and negative correlations with the rest of Asia and the U.S.

The opposite of a positive correlation is an inverse relationship known as a negative correlation – when one goes up the other goes down. Market dynamics are the movements of supply, demand, and other forces that influence pricing. During the 2020-21 pandemic, online business flourished. People started buying groceries and other commodities through e-merchants, whereas offline businesses like grocery shops, and restaurants shut down their shops without any business. When digital payments like UPI, and QR code goes up cash transactions considerably come down. While stock market prices soar, bonds fall representing a “risk on” sentiment. Bond prices can move higher as stock prices move lower, and gold prices can go up when the dollar falls— Similarly Silver tends to correlate positively with gold, while other assets tend to move in tandem. The hike in oil prices results in shrinking margins for transports; hence, a negative correlation exists between crude oil and transports consuming petrol, and diesel. Just like oil, natural gas is inclined to have a positive correlation with crude oil.  Generally, when RBI hikes key policy rates like the Repo rate money flow races into Bank deposits, bonds, and fixed-income instruments as it leaves stocks and vice versa when rates are cut.

The IMF’s recent ‘spillover’ analysis—how what happens in one country affects others—reinforces the importance of this interconnectedness.  When U.S. Federal interest rates increase while the dollar appreciates, the exchange rate between developing nations and the United States tends to widen. As a result, dollar-denominated debt owed by developing nations increases and becomes unmanageable.

When the Federal Reserve of the US hikes interest rates, the Indian markets and the economy are negatively impacted. The Indian market in such a situation is inclined to come down because foreign investors pull out, foreign exchange reserves start to deplete, the economy is at risk of mounting inflation, the rupee falls against the dollar, etc. due to capital outflows.

A seemingly insignificant situation or change can lead to a series of compounding events resulting in a much larger and seemingly unrelated catastrophe elsewhere down the road.

The prices of fuels in the EU have risen as a consequence of the current Russia-Ukraine war. Russia and Ukraine are major commodities producers, and disruptions in the supply chain have caused global prices to soar, especially for oil and natural gas. Food costs have jumped, with wheat, for which Ukraine and Russia make up 30 percent of global exports, reaching a record.

The American subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the 2007–2008 global financial crises. It was triggered by a large decline in US home prices after the collapse of a housing bubble, leading to mortgage delinquencies, and foreclosures. The crisis led to a severe multinational economic recession, with millions of people losing their jobs and many businesses going bankrupt.

On July 1, 1997, the central bank of Thailand devalued their currency Baht. This caused a chain reaction of falling stock markets and asset price devaluations as private debt exploded throughout Asian markets from South Korea, Philippines, Laos, and Malaysia to Singapore, Taiwan, Vietnam, Indonesia to Japan, Hong Kong, and even mainland China and eventually leading to a U.S. stock market crash four months later.

Conclusion:

This interconnectedness of markets suggests that what happens in one market could affect other markets.

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