Relationship between Bond Spreads and Forex
Very few traders realize it, but bond spreads have an immense value when trading Forex on a daily/weekly basis. In this guide, we’ll show how you can use this technique to improve your Forex trading.
Firstly, let’s see what ‘spread’ means in this context. Usually, in Forex, the spread is the difference between the bid and ask prices. However, here we are concerned with a different kind of spread: the bonds yields spread. For example, if US 10y bonds yield is 2%, and UK 10y bond yield is 1.5%, the spread would be 0.5 percentual points. Higher spreads suggest that interest rates are higher in a country relative to another. As we will see, these spreads can be valuable in trading.
How do Bonds Spreads affect the Forex market?
Now that we know what the bonds spread is, it’s important to understand how spreads influence the Forex market. This relation depends on one main factor – interest rates. Interest rates are the basis of any bond, and higher interest rates will mean higher bond yields. Interest rates can affect the Forex market because of 2 main reasons:
1. Institutional and Private Investors
Yields are dependent on the interest rate defined by Central Banks. If the Fed or the ECB decide to increase interest rates, bond yields from the respective companies will also increase. This happens because bonds are dependent on the interest rate from the country where they are issued. A rise in interest rates means bonds will pay a higher interest, i.e., have a higher yield. Investors will, therefore, get higher returns.
When interest rates are higher in country A relative to country B, bonds from country A are more attractive. Investors will prefer to put their money in these bonds since they pay higher coupons.
To buy bonds, investors will need to exchange their currency for the currency in which bonds are traded. So, the currency with higher yield bonds will have a higher demand.
2. Central Banks
As already said, the price of bonds depends on the interest rates defined by central banks. According to their monetary policies, central banks buy or sell bonds in order to achieve the desired interest rate. To raise the interest rate, central banks sell bonds, increasing supply and reducing bonds prices. Bond yields and their prices go in opposite directions so, when central banks raise interest rates, prices fall and yields rise. In this sense, when central banks sell bonds, they are withdrawing money out of the economy. This will make the currency appreciate. The reduction of money in circulation makes each unit to worth more.
Both arguments explain the positive correlation between bonds spreads and forex. From one side, higher interest rates will attract more investors. These investors will increase the demand for the currency in which the bond is traded. On the other hand, higher interest rates mean Central Banks are selling bonds, which reduces the supply of money in the economy. The two will contribute to an appreciation of the domestic currency.
Simply put, between two countries, the currency of the country with higher interest rates tends to appreciate.
Looking at some examples…
Traders can expect an appreciation in the domestic currency after a rise in interest rates. We can see this positive correlation between bond spreads and forex in the following charts.
Although the correlation between bonds and spreads is positive in the overall picture, there are periods where both diverge from each other. Those divergence periods are annotated in red.
USD/JPY vs US 10Y / JP 10Y Yield Spreads
In this chart, it’s possible to see a very close correlation between US bonds and Japanese bonds spreads and USD/JPY. However, there are two main periods we want to highlight:
Divergence (in red): During the period from December 2011 to April 2016, there was only one period in which the positive correlation did not stand. The period signaled in red shows a high volatility in bond spreads while the pair traded relatively flat. This is a divergence.
Spreads leading USDJPY (in yellow): we see how the major increase in spreads that happened in August 2013 only affected the forex market one year later. Actually, it’s very common to see this lag correlation, usually with spreads usually leading the pair between 2 and 10 months.
GBP/USD vs UK 10Y / US 10Y Yield Spreads
Spreads leading Pair (in yellow): We can see yet again, in this chart, how a major drop in the forex market follows a major drop in spreads only months later. Both charts show how, very often, spreads movements lead the Forex pair’s movement.
Divergences (in red): In 1 and 3, GBP/USD rose while bonds went down, while in 2 and 4, the contrary happened.
How can traders benefit from this relationship?
Traders may profit from the above-mentioned correlation in two main ways:
1. Through carry trade. It involves borrowing in the country that has a lower interest rate and buying a bond in the country with the highest. As long as the exchange rate remains the same, the bond spread is the profit. However, this strategy can be risky, since the movements in the Forex pair will ultimately compensate for that differential. In practice, this has to be implemented within a hedging strategy.
2. Divergences between spreads and the Forex pair. We know that spreads usually lead the Forex pair by some months, so when they diverge, we know that the pair’s movement is nearly ending. For example, if GBP/USD is rising, but the bonds spreads are falling for some months already, you should be getting ready to short GBP/USD.
All the data collected for the research was extracted from www.investing.com.
The relationship between bonds spreads and forex is a very useful analysis to forecast movements in certain pairs. However, traders should do a more broad analysis of the market before entering a position. In the article Intermarket Relationships in Forex, we explain how other factors such as the price of commodities and stocks also affect the Forex market.