Bond spreads have a profound influence in the forex market. This is in tandem with many of the correlations we see between currencies and other markets such as the stock markets and the commodity markets. In this article, we will show the correlation between forex and bond spreads.
What are Bond Spreads?
What are bond spreads? The bond spread is the difference in the yield of one bond and another bond.
Specifically, it is used to describe the yield spread difference of the bond yields of two countries. In the forex market, the difference in the interest rate yields of two countries form the basis of the carry trade in forex. The carry trade is the practice of purchasing (i.e. taking a long position in) the currency of a country with a higher interest rate, and shorting the currency of a currency with a lower interest rate at the same time, with the expectation of earning an interest payment on overnight positions throughout the duration of the trade.
After the dot.com bubble of 2000, many hedge funds and investors decided to look for more guaranteed ways of earning from the market, and many of them went to countries with higher interest rates such as Australia and New Zealand, abandoning the bonds of the US (whose interest rate was less than 2% at the time) and Japan (whose interest rate was less than 0.6%). This led to a period between 2001 and 2008 when there was massive capital shift towards the Australian Dollar and the New Zealand Dollar in the forex market. At the height of the carry trade, the interest rate of Australia was at 8.25%. This strategy unwound when the global financial crisis hit, forcing the Australian government to sequentially drop interest rates as part of a coordinated stimulus for the global economy undertaken by the world’s major central banks.
Now how do bond spreads influence trades in the currency market? From what we have just discussed, it is obvious that when the bond spread between two countries widens, traders will naturally gravitate towards holding more of the stronger interest yielding currency, and this increased demand for one currency over another will lead to appreciation of that currency in the forex market. This was what pushed the carry trade strategy and a look at the historical charts of the AUDUSD, AUDJPY, USDCAD, NZDJPY and NZDUSD. Again, due to the sheer volume of these trades from hedge funds and high net-worth investors as well as other institutional investors, the extent of the appreciation of these currency pairs was enhanced.
So for a trader wishing to trade the forex market using bond spreads should simply look for a currency pairing that matches a higher yielding currency with a lower yielding one, subscribe to news services that give the trader information as to the order flows, and take a long position on the currency with the higher bond yield while shorting the currency with the lower bond yield.
The Technique of Trading Forex With Bond Spreads
When trading forex with bond spreads, the following information is what the trader needs to get in order to get the timing of the trades right:
a) Order flows.
b) Change in yield spreads.
c) Economic assessment by the central banks with regards to monetary policy.
Whenever a carry trade opportunity exists, for instance when a country like Australia or Canada start to raise interest rates again as a result of inflationary pressures, and Japan and the US keep their rates at all-time lows, we will see the big dogs pushing their money into these higher yielding currencies once more. If you use an institutional trading platform with Level II quotes, you will get an idea of the volumes held in a particular currency by certain big players in the market. Such order flows will immediately tell a trader when a higher-yielding currency has assumed a very strong bid status.
Change in Yield Spreads
Certain conditions can cause the yield spreads to start changing very fast. One of those situations is when the markets assume a “risk-off” appetite, or when investors become risk averse. Risk aversion has a very potent forex market impact, and typically arises when there is a negative trade balance situation. The trade balance is one of the news items released in the forex markets. When a country spends more than it makes and racks up a high deficit, investors get easily spooked because this is a sure sign that a country may default on its bond payments. Such countries are therefore forced to offer investors higher interest rates as an incentive to get them to continue to buy bonds. In the forex market, this sets off a risk aversion-based portfolio adjustment where currencies with higher yields are sold off. This causes a depreciation of these currencies. So a trader in the forex market can simply sell a higher yielding currency when there is a situation of risk aversion in the markets.
The same situation also occurs if a country with a high interest rate has to start cutting rates to stimulate its economy. We can see that change in yields also works for downside trades as well as upside trades. It is simply a matter of knowing what to do in certain market situations.
Economic Assessment with Regards to Monetary Policy
Following on from the last paragraph, we will round off this discussion by stating that whatever factor(s) that force a central bank to reconsider monetary policy must be taken into consideration by traders who want to trade forex based on bond yields. Central banks understand that interest rates can be used to control the level of inflation in an economy, and this happens in two ways.
Firstly, by increasing the interest rate in a country, a central bank will make it more expensive to access finance and this restricts monetary supply and will therefore keep prices in check. Secondly, increasing interest rates will push investments into an economy as investors seek to make more money from that country’s bonds. This will keep that country’s currency strong and prevent the runaway inflation that plagues countries whose currencies experience sharp depreciations.
These relationships can all be exploited by traders who wish to trade forex using bond spreads.