Positioning according to bond spreads
This lesson will cover the following
- Importance of interest rate decisions
- How bond spreads affect a currency’s value
- Carry trades
In the previous article, we discussed the role of commodity price changes as a leading indicator for currency movements, particularly for commodity-based currencies. In the current article, we will turn our attention towards bond spreads and how a trader can interpret changes in them to predict the appreciation or depreciation of a currency relative to its counterpart.
When it comes to forex trading, the interest-rate differential is the gap between the interest rate on the base currency (in AUD/USD, the AUD) and the rate on the quote currency (the USD). When a central bank alters interest rates, this affects its currency in both the short term and the long term. However, the impact of the bank’s decision is not limited to the national currency; it also influences all of its crosses. Thus, if a major economy’s central bank deploys this monetary tool to steer the economy in a desired direction, the effect will reverberate throughout the entire foreign-exchange market. We have spoken extensively about the Federal Reserve’s role on the global economic scene, and we know what kind of volatility is experienced before, during and after the Federal Open Market Committee’s meetings, where policymakers decide on interest rates and the pace of bond purchases under the Quantitative Easing programme.
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Leading indicators
Grasping the relationship between rate differentials and currency pairs can yield substantial returns, which is why traders use fixed-income instruments such as 10-year bond yields as leading indicators for currency fluctuations. In case you missed it, leading indicators provide insight into future developments so that you can base predictions of price changes on them with a relatively high degree of confidence. Whether an indicator is regarded as leading depends on how the majority of traders interpret it and whether they believe it has more significant implications for the future state of the market than for the present. In our case, if rate differentials are perceived by the public as indicative of future currency movements, they will be treated as leading indicators. Alternatively, they may be considered coincident or lagging indicators.
In general, however, interest-rate differentials are deemed leading indicators. Because most investors actively seek higher returns, both individual and institutional traders continually redirect capital from lower-yielding currencies to higher-yielding ones. Thus, it is important not only to be aware of the central bank’s current rate decisions, but also to stay informed about expected changes and their timing in order to anticipate fluctuations in currency crosses. Bear in mind, however, that currency movements are influenced by a wide array of economic data (economic indicators, macroeconomic events, central bankers’ speeches), so the correlation between interest-rate differentials and currency fluctuations is not perfect. It is best applied over the long term, as the spikes caused by scheduled releases are eventually smoothed out.
Carry trades
As a currency’s yield spread relative to its counterpart widens in its favour, more investors will buy that currency to benefit from the higher return. According to the supply-demand principle, increased demand for the currency implies that its value will appreciate against its trading peers. One of the main fixed-income instruments used to determine in which currency to invest is the long-term government bond, particularly the 10-year bond.
For example, if the New Zealand 10-year government bond yield is 4.5%, while the 10-year US government bond yield is 1.5%, New Zealand enjoys a 3% bond-spread advantage, or 300 basis points. If New Zealand were to raise interest rates, pushing yields to, say, 5%, demand for the New Zealand dollar would rise further and the currency would be expected to appreciate against the US dollar.
The most practical way to use this strategy regularly and keep track of everything is to enter the required data into spreadsheet software. Create separate columns for the base currency’s interest rate, the quote currency’s rate, the interest-rate differential (calculated by subtracting one from the other) and the corresponding currency pair. After compiling data over a sufficiently long period, you will begin to observe the correlation between these elements.