The relationship between forex and bonds




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The relationship between forex and bondsThe Relationship Between Forex and Bonds

The markets are heavily correlated. We see examples of correlations in commodities and forex, where crude oil prices directly affect the value of the US Dollar, Canadian Dollar and Japanese Yen. We also see similar correlations between the value of the Nikkei 225 (a stock index) and the Japanese Yen, or the correlation between gold prices and the Australian Dollar. Indeed, a look at the gold charts and that of the AUDUSD will show that the rapid drop in the price of gold has also dragged down the value of the Australian Dollar when compared with other majors such as the US Dollar, Euro and Canadian Dollar. This goes to show that the markets should not be traded in isolation. Traders must always study the relationship between a particular currency and another market asset in the commodities, index or futures markets, so that the basis of a price movement can be thoroughly understood. In addition, information about the market potential for price volatility based on the occurrences in other markets can also be understood very clearly.

In this article, we shall examine the relationship between the forex market and the bond market. Not many traders know that there is a relationship between forex and bonds, let alone know the interplaying factors between both assets. That is what this article seeks to show so that traders will no longer be in the about how bonds and currencies affect each other.

BONDS: WHAT ARE THEY?

What are bonds?

Bonds are money market debt instruments which can be used by governments and corporations as a means of accessing cheap borrowed funds. Bonds are commonly issued by governments at all levels (Federal, State and Local/Municipal governments), and less commonly by corporate bodies. They provide a source of cheaper borrowing when compared with bank loans, and that is what makes them desirable. In addition, the bond issuer usually sets the terms of borrowing and financing, essentially giving the borrowing entity the ability to set repayment rates at the borrower’s convenience. It is then up to the lender to decide if the borrowing terms and repayment percentages, interests and plans are suitable.

Bonds go by different names. They are also called Treasuries, Treasury Yields, Government Notes, etc. Bonds also have different maturity times. Bond buyers are paid periodic interests for their investments, so we have bonds that have 30-day yields, 60-day, 90-day, 120-day, 3-year, 5-year, 10-year and 30 year yields.

Bond Yields and Bond Prices

We see these terms used a lot when describing bonds, so it is important for us to describe what they are so that the trader understands what these terms stand for. The bond price refers to the cost of the bond (which is what the bond buyer pays when buying the bond) while the bond yield is the interest that the bond buyer is paid by the bond issuer for the use of the bond buyer’s money.

The bond price is inversely related to the bind yield. When bond prices rise, yields fall and vice versa.

RELATIONSHIP BETWEEN FOREX AND BONDS

How are bonds related to the value of currencies? Certain characteristics of bonds will affect the value of a currency. These are:

a) Bond Yields

b) Bond Spreads

Bond Yields and Currencies

Bonds are traditionally lower yielding investments when compared to currencies, but are regarded as safer investments because the interest yields on the bond instruments are almost always guaranteed. Therefore, traders mostly purchase bonds when there is uncertainty in other markets. Thus, bond-buying is associated with “flight to safety” or risk aversion. Once risk aversion is full in play in the markets, bond prices will traditionally start to rise and bond yields will correspondingly fall.

A classical example of how a currency relates to a bond is the relationship between the US Dollar the 10-year Treasury Note. The currency of a country and its bond price are inherently tied to the interest rate of the country (which actually serves as the benchmark for the bond yield). When retail prices rise, there is a risk of inflation which increases the likelihood of interest rate increases, which leads to higher bond yields. Higher bond yields will lead to higher demand for the local currency as foreign investors exchange their currency for the local currency in order to buy the bonds of the affected country. This upsurge in demand will lead to a rise in the value of the currency. Therefore, rising yields of the bond will lead to a higher currency value, while falling yields will lead to a drop in the value of a currency.

When looking at the yield of the 10-year US Treasury Note and the US Dollar, we can see that there is a positive correlation. The charts below illustrates this point:

The 1-year chart movement for the Bond Yields on the US 10-Year Treasury Note

1 Year Chart for USDCAD (Daily)

The following charts are an illustration of the correlation between a currency pair containing the USD (USDCAD) and the 10-year US Treasury Note. We see the 10-year US Treasury Note behaving in a similar pattern to the USDCAD currency movement. Both charts are representative of the price movements and bond yields of the two assets.

We can clearly see that with a rise in the bond yields, there is a corresponding rise in the USDCAD. Areas where there is a dip in the bond yields correlate with a dip in the price of the USDCAD. This goes to highlight the relationship between the 10 year Note and the US Dollar. Increase in bond yields will always attract investor interest into the currency of the affected country, spurring a demand-driven rise in the currencys value.

Bond Spreads and Currencies

We have heard about spreads when dealing with the bid and ask price of a currency pair. Spreads also exist in the bond market, and bond spreads simply refer to the difference in the bond yields of two countries in comparison. Usually, the currencies of those countries whose bond yields are compared in spreads are those that are found in the forex market.

Have you ever heard of the carry trade? If you have, then this is the entire basis of the carry trade in forex. In case you have not and you are yet to read about the carry trade from one of the previous articles on this site, then we will explain the carry trade once again. The carry trade is simply one of the forex trading strategies in which a trader seeks to gain from the differential in bond yields/interest rates of two currencies paired together. Usually, the best gains are made when a currency with a relatively high bond yield is traded against another currency with the lowest bond yield.

The height of the carry trade was in 2006/2007 when Japans bond yields were very low (not more than 0.5%) and that of countries like Australia (8.25% at a point), Britain and Canada were much higher. Many traders made incredible profits trading the AUDJPY and GBPJPY in those years. The global financial crisis caused many countries to cut interest rates, unwinding the carry trades to some extent. However, some measure of carry trading still exists as there is still a reasonable differential between the interest rates of Australia and Canada on one hand, and that of the US and Japan on the other, providing opportunities to make money from the bond yield differentials available by trading the AUDUSD and AUDJPY.

Traders can capitalize on this in the following ways:

a) Look for long-term opportunities to buy the AUDUSD. Presently, the AUDUSD is in a downtrend as gold prices have tanked in recent weeks. Any fundamental factor which pushes the price of the AUDUSD upwards from its present levels will present an opportunity to benefit from a long position on this pair. The opportunity should be sought for on the daily charts, providing an opportunity to hold the position for days or weeks, and earning interest every day as the position is rolled over.

b) Look or long term opportunities to sell the USDCAD using the same principles outlined above.

CONCLUSION

Going forward, traders can use these bond resources to trade currencies. One of the important resources on bonds is the list of bond spreads and bond yields from country to country. There are several websites where this information is available. Using this information, it will be possible for traders to identify other currency pairs where there is a sufficient interest rate differential to profit from bond yields and bond spreads.

Traders should also know that most of these opportunities are medium to long term. Apart from the daily rollover paid out for holding a long position on a high bond yielding currency (which requires large positions to be meaningful), traders are encouraged to hold such positions for days or weeks when the trend favours the higher yielding currency. This is the only way that profiting from bond yields and bond spreads will provide the maximum profits accruable.

Attention!

The author’s views are entirely his or her own.