Bond Spreads A Forex Leading Indicator

The world’s markets are all connected in one way or another. We commonly observe commodity and futures prices influence currency fluctuations and vice versa. The relationship between currencies and bond spreads (the difference between countries’ interest rates) is similar: currency prices can influence central banks’ monetary policy decisions around the world, but monetary policy decisions and interest rates can also drive currency price movement.

Understanding the Relationship Between Bond Spreads and Currencies

Bond spreads yields have an important influence in influencing a currency’s trajectory. The interest rate differential, or the difference between one country’s bond yield and another country’s bond yield, has a greater impact on the direction of a currency than the actual bond yield. Bond yields move in lockstep with the equivalent currency pair when interest rates diverge between two countries. 

A stronger currency helps to keep inflation low, whereas a weaker currency causes inflation to rise. This link is used by central banks as an indirect manner of managing their respective countries’ monetary policy. Investors can gain insight into the currency market by understanding and analyzing these linkages and trends, and thereby predict and profit from currency moves.

Currency pairs are the most fundamental securities traded on the foreign exchange market. The relative rate between one country’s currency and another country’s currency is referred to as a currency pair. For example, if the EUR/USD currency pair’s exchange rate is 1.3, an investor can buy 1 Euro for $1.30. When an investor trades a currency pair, he or she is simultaneously buying and selling one currency. A trader who buys EUR/USD, for example, is buying Euros and selling dollars.

Currencies And Interest

We can go back in time to discover how interest rates have influenced currency decisions. After the tech bubble burst in 2000, traders shifted their focus from pursuing the biggest possible returns to capital preservation. However, because interest rates in the United States were below 2% (and even lower), many hedge funds and those with access to overseas markets looked for higher yields elsewhere.

With the same risk factor as the United States, Australia provided interest rates of above 5%. As a result, it drew enormous amounts of investment capital into the country, as well as assets denominated in the Australian dollar.

The carry trade, an interest rate arbitrage strategy that takes advantage of interest rate differentials between two major economies while seeking to profit from the currency pair’s general direction or trend, arose as a result of these huge interest rate discrepancies. This transaction entails purchasing one currency and financing it with a different one. Because of their countries’ unusually low-interest rates, the Japanese yen and Swiss franc are the most widely used currencies to fund carry trades.

One of the main reasons for the strength seen in pairs such as the Australian dollar and the Japanese yen (AUD/JPY), the Australian dollar and the United States dollar (AUD/USD), the New Zealand dollar and the United States dollar (NZD/USD), and the United States dollar and the Canadian dollar (USD/CAD) is the popularity of the carry trade.

Individual investors, on the other hand, find it difficult to transfer funds between bank accounts all around the world. Any increased yield sought by investors may be countered by the retail spread on exchange rates. Investment banks, hedge funds, institutional investors, and major commodity trading advisors (CTAs), on the other hand, typically have access to these worldwide markets as well as the clout to command low spreads.

As a result, they move money around in quest of the best rates while minimizing sovereign risk (or risk of default). The bottom line is that exchange rates fluctuate in response to changes in money flows.

Investors’ Perspective

Individual investors can profit from these changes inflows by keeping an eye on yield spreads and the expectations for interest rate changes that may be inherent in those spreads.

In the summer of 2000, when the yield spread began to climb again, the Australian dollar responded with a similar surge a few months later. Over the next three years, the Australian currency’s 2.5 percent spread advantage over the US dollar corresponded to a 37 percent increase in the AUD/USD.

Traders that we’re able to enter this transaction not only profited from the large capital gain, but also from the annualized interest rate discrepancy. As a result of the foregoing relationship, if the interest rate disparity between Australia and the United States narrowed (as projected) from the last date displayed on the chart, the AUD/USD would eventually decline as well.

This relationship between interest rate differentials and currency rates is not exclusive to the AUD/USD; similar patterns can be found in the USD/CAD, NZD/USD, and GBP/USD.

The fluctuation in the interest rate differential between New Zealand and the United States has historically been paralleled by the currency pair. If the yield spread between New Zealand and the United States continues to narrow, the yield spread between the NZD and the USD is likely to reach its peak.

Other Assessment Factors

Currency spreads can be used to measure both five- and ten-year bond rates. The general rule is that when a currency’s yield spread increases in its favor, that currency gains value against other currencies. However, keep in mind that currency fluctuations are influenced not only by actual interest rate changes but also by changes in economic assessment or central bank interest rate hikes or cuts.

Shifts in the Federal Reserve’s economic assessment, as shown in the figure, tend to cause dramatic changes in the US currency. The graphic shows that when the Fed switched from an economic tightening (indicating it planned to raise rates) to a neutral view in 1998, the dollar declined even before the Fed made a rate adjustment (note that on July 5, 1998, the blue line plummets before the red line).

The dollar moved in the same direction when the Fed switched from a neutral to a tightening bias in late 1999, and then again when it switched to a looser monetary policy in 2001. In fact, the dollar suffered a severe sell-off as soon as the Fed even discussed cutting rates. Investors would expect a little more opportunity for the dollar to rally if this link holds in the future.

When Interest Rates Aren’t Enough to Predict Currencies

Despite the fact that this approach for forecasting currency fluctuations works in a wide range of scenarios, it is far from the Holy Grail of currency trading. There are several instances in which this method could backfire:

Impatience

These interactions, as seen in the instances above, promote a long-term plan. Currency bottoming out could take up to a year after interest rate differentials have bottomed out. The success of this technique may be greatly reduced if a trader cannot commit to a time horizon of at least six to twelve months. What is the explanation for this? Over time, currency valuations reflect economic fundamentals. Temporary imbalances between currency pairs are common, and they can obscure the genuine underlying fundamentals between those countries.

Excessive Leverage

Traders that use excessive leverage may not be suited to the strategy’s breadth. For example, a trader using 10 times leverage on a yield differential of 2% would turn 2% into 20%, and many organizations provide up to 100 times leverage, pushing traders to take a bigger risk and try to turn 2% into 200 percent. However, leverage carries danger, and using too much leverage might cause an investor to exit a long-term trade early because they are unable to withstand short-term market volatility.

The risks of exerting too much leverage are rarely discussed, but they are very evident when you consider them. This isn’t to say that you have to use all of the leverage just because it’s available. In fact, there are a variety of strategies to employ to leverage to your benefit.

When adding to a profitable transaction, leverage is a solid option. This is an excellent use of leverage if you have a transaction that has performed well and you want to add to it. This is referred to as profit leveraging.

When it comes to leverage, position trading is the greatest option. It’s tempting to utilize high leverage to make quick money on single trades, but the dangers aren’t worth it. This is especially true given the uncertainty of the future.

Equities Have Been Increasingly Attractive

The lack of attractive equity market returns was the key to yield-seeking trades’ success in the years since the tech bubble burst. Despite a zero-interest policy, the Japanese yen soared over a period in early 2004. 6 The reason for this was that the stock market was on the rise, and the prospect of larger returns drew many underweighted funds in. Over the previous ten years, most large players have reduced their exposure to Japan due to the country’s protracted period of stagnation and zero interest rates. Regardless of Japan’s continuing zero-interest policy, money poured back into the country when the economy showed indications of recovery and the stock market began to surge once more.

This shows how the importance of equities in the capital flow can make bond yields less accurate at anticipating currency changes.

Hazardous Environment

Forex markets are mostly driven by risk aversion. In a risk-seeking climate, currency trades based on yields are most successful, whereas in a risk-averse environment, they are least successful. Investors prefer to reorganize their portfolios in risk-seeking situations, selling low-risk/high-value assets and buying higher-risk/low-value ones.

Riskier currencies, such as those with big current account deficits, are required to charge a higher interest rate to compensate investors for the risk of a quicker depreciation than uncovered interest rate parity predicts. An investor’s reward for assuming this risk is a greater yield. When investors are more risk-averse, however, the riskier currencies—on which carry trades rely on their profits—tend to decline. Riskier currencies typically have current account deficits, and as investors’ appetite for risk wanes, they withdraw to the safety of their home markets, making these deficits more difficult to cover.

In times of increased risk aversion, it seems prudent to unwind carry transactions because unfavorable currency movements tend to at least partially offset the interest rate benefit. Many investment banks have created early warning indicators for increased risk aversion. This involves keeping an eye on emerging-market bond spreads, swap spreads, high-yield spreads, FX volatility, and stock market volatility. Risk-seeking indicators include tighter bonds, swaps, and high-yield spreads, and risk-aversion indications include reduced forex and equity-market volatility.

Particular Points to Consider

Although there are dangers associated with utilizing bond spreads to forecast currency fluctuations, sufficient diversification and attentive attention to the risk environment will help to increase results. This method has worked for many years and may continue to work in the future, but deciding which currencies are emerging high-yielders vs emerging low-yielders may change over time.

Interest rates are an important aspect of financial decisions and can push markets in either direction, as any trader can confirm. After nonfarm payrolls, the Federal open market committee (FOMC) rate decisions are the second most market-changing release for currencies. Fixed income instrument yield differentials, such as Libor rates and 10-year bond yields, can be utilized as currency movement leading indicators. An interest rate differential is a difference between the interest rate of a base currency and the interest rate of the quoted currency in foreign exchange (FX) trading. Understanding the relationship between interest rate differentials and currency pairs may be extremely beneficial, especially as interest rate differentials are the single most important driver of currency movements. The importance of future rates vs current rates determines whether interest rate differentials are a leading, coincident, or lagging indicator of currency pair pricing.

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