It goes like this:
Currencies are the quickest and smartest kids in the class. They are the ones with their hand constantly in the air and (nearly) always have the right answer. Basically, you need to follow the currency markets to see what’s what. The currency markets cotton on to stuff quicker than anything else, so understanding the movements there will give you a clearer picture of the overall market environment. The reason currency markets are the quickest of cats is because they are massive. I mean HUGE. Not in the sense Donald Trump says it—I mean really, really, proper huge! A market doesn’t get any more efficient than the currency markets.
Not many people know this since equities tend to get the attention in the mainstream media, but bond markets dwarf equity markets. So they’re pretty hefty too. If nothing is happening in the currencies, then chances are bond markets will know. They’ll know better than equity markets that’s for sure. Just remember to watch both the longer bonds and the shorter bonds; are yields going up or are they going down?
Finally, it’s equities. These are the cool kids in the class, they’re exciting, they’re fun, they get all the pretty and naughty girls. And everyone secretly wishes they possessed the same devil-may-care attitude. The problem is they may well have that attitude and truly be in for a fun ride, but they’re also the slowest of the bunch when it comes to brains. They are the last to comprehend what’s going on.
Let’s take a case in point: The current US government shutdown this week. You’re seeing a clear weakening in the US dollar against the euro. This shows that the currency markets are a little more than worried about what could happen in the US as they sell their dollars. Bond yields are uncertain, don't really know if they are coming or going, so they aren’t sure of what’ll happen (see my previous post why). As for equities? Well, they aren’t worried—no big moves and the volatility index (VIX) often referred to as the fear index is still at low levels.
These are the kinds of situations that should be getting attention: currencies worried, bonds uncertain, and equities relaxing. They are not common occurrences, and in this environment, I’d be very cautious indeed.