The bond spread is the differential in bond yields between two countries.
These distinctions give birth to carry trading, which we explored previously.
You may predict the direction of currency pairs by keeping an eye on bond spreads and interest rate forecasts.
This is what we mean:
The currency of the country with the higher bond yield rises versus the currency of the country with the lower bond yield as the bond spread between the two countries increases.
This tendency may be seen by examining the graph of the AUD/USD price action and the bond spread between Australian and US 10-year government bonds from January 2000 to January 2012.
From 2002 to 2004, as the bond spread increased from 0.50% to 1.00%, the AUD/USD increased by over 50%, jumping from.5000 to 0.7000.
When the bond gap increased from 1.00% to 2.50% in 2007, the AUD/USD increased from.7000 to just above.9000.
That’s 2000 pips!
When the 2008 crisis hit and all major central banks began to cut interest rates, the AUD/USD fell from the.9000 level to 0.7000.
So, what exactly happened here?
One possible explanation is that traders are taking advantage of carry transactions.
When bond spreads between Australian bonds and US Treasuries widened, traders increased their long AUD/USD positions.
WHY?
The GBP/USD fell as the bond spread between the UK bond and the US bond narrowed.
How Fixed Income Securities Affect Currency Movements
So far, we’ve covered how disparities in rates of return might be used to predict currency price movement.
When the bond spread or interest rate disparity between two economies widens, the currency with the greater bond yield or interest rate gains value against the other.
Fixed income securities (including bonds) are investments that offer a fixed payment at regular time intervals.
Economies that offer higher returns on their fixed income securities should attract more investments.
This would make their local currency more appealing than those of other economies with lower fixed-income returns.
Consider gilts and Euribors (we’re talking about British bonds and European securities here!).
If Euribors offer a lower rate of return than gilts, investors will be discouraged from investing in the eurozone’s fixed income market and will prefer to invest in higher-yielding assets.
As a result, the EUR may lose ground versus other currencies, particularly the GBP.
This tendency occurs in practically every fixed-income market and currency.
You can compare the yields on Brazilian fixed-income securities to those on Russian fixed-income securities and use the differences to forecast the behavior of the real and the ruble.
If you wish to try your hand at these relationships, you can find data on government and business bonds on these two websites:
- Trading Economics
- Bloomberg
You can also get current bond yields by visiting the government website of a specific country. They are usually rather accurate. They are the ruling class.
In fact, most countries sell bonds, but you should stick to those whose currencies are part of the major currencies.
Here are some of the most popular ties from throughout the world, along with their catchy nicknames:
| ECONOMY | BONDS OFFERED |
|---|---|
| United States | U.S. Treasury bonds, Yankee bonds |
| United Kingdom | Gilts, Bulldog bonds |
| Japan | Japanese bonds, Samurai bonds |
| Eurozone | Eurozone bonds, Euribors |
| Germany | Bunds |
| Switzerland | Swiss bonds |
| Canada | Canadian Bonds |
| Australia | Australian Bonds, kangaroo bonds, Matilda bonds |
| New Zealand | New Zealand bonds, Kiwi bonds |
| Spain | Matador bonds |
Some countries also sell bonds with differing maturity periods, so make sure you are comparing bonds with the same maturity term (for example, 5-year gilts against 5-year Euribors), or your analysis will be incorrect.
