FOREX & CURRENCIES TRADING ADVANCED FOREX TRADING CONCEPTS

Bond Spreads: A Leading Indicator For Forex

BY KATHY LIEN | Updated Oct 7, 2018

The global markets are really just one big interconnected web. We frequently see the prices of
commodities and futures impact the movements of currencies, and vice versa. The same is true
with the relationship between currencies and bond spread (the difference between countries\'
interest rates): the price of currencies can impact the monetary policy decisions of central banks
around the world, but monetary policy decisions and interest rates can also dictate the price
action of currencies. For instance, a stronger currency helps to hold down inflation, while a
weaker currency will boost inflation. Central banks take advantage of this relationship as an
indirect means to effectively manage their respective countries\' monetary policies.

By understanding and observing these relationships and their patterns, investors have a
window into the currency market, and thereby a means to predict and capitalize on the
movements of currencies.

Interest and Currencies

To see how interest rates have played a role in dictating currency, we can look to the recent
past. After the burst of the tech bubble in 2000, traders went from seeking the highest possible
returns to focusing on capital preservation. But since the U.S. was offering interest rates below
2% (and going even lower), many hedge funds and those who had access to the international
markets went abroad in search of higher yields. Australia, with the same risk factor as the U.S.,
offered interest rates in excess of 5%. As such, it attracted large streams of investment money
into the country and, in turn, assets denominated in the Australian dollar.

These large differences in interest rates led to the emergence of the carry trade, an interest rate
arbitrage strategy that takes advantage of the interest rate differentials between two major
economies while aiming to benefit from the general direction or trend of the currency pair. This
trade involves buying one currency and funding it with another, and the most commonly used
currencies to fund carry trades are the Japanese yen and the Swiss franc because of their
countries\' exceptionally low-interest rates. The popularity of the carry trade is one of the main
reasons for the strength seen in pairs such as the Australian dollar and the Japanese yen
(AUD/JPY), the Australian dollar and the U.S. dollar (AUD/USD), the New Zealand dollar and the
U.S. dollar (NZD/USD), and the U.S. dollar and the Canadian dollar (USD/CAD). (Learn more
about the carry trade in The Credit Crisis And The Carry Trade and Currency Carry Trades
Deliver.)
However, it is difficult for individual investors to send money back and forth between bank
accounts around the world. The retail spread on exchange rates can offset any additional yield
they are seeking. On the other hand, investment banks, hedge funds, institutional investors and
large commodity trading advisors (CTAs) generally have the ability to access these global
markets and the clout to command low spreads. As a result, they shift money back and forth in
search of the highest yields with the lowest sovereign risk (or risk of default). When it comes to
the bottom line, exchange rates move based upon changes in money flows.

Insight for Investors

Individual investors can take advantage of these shifts in flows by monitoring yield spreads and
the expectations for changes in interest rates that may be embedded in those yield spreads. The
following chart is just one example of the strong relationship between interest rate differentials
and the price of a currency.

Figure 1
Notice how the blips on the charts are near-perfect mirror images. The chart shows us that the
five-year yield spread between the Australian dollar and the U.S. dollar (represented by the blue
line) was declining between 1989 and 1998. This coincided with a broad sell-off of the Australian
dollar against the U.S. dollar.

When the yield spread began to rise once again in the summer of 2000, the Australian dollar
responded with a similar rise a few months later. The 2.5% spread advantage of the Australian
dollar over the U.S. dollar over the next three years equated to a 37% rise in the AUD/USD.
Those traders who managed to get into this trade not only enjoyed the sizable capital
appreciation, but also earned the annualized interest rate differential. Therefore, based on the
relationship demonstrated above, if the interest rate differential between Australia and the U.S.
continued to narrow (as expected) from the last date shown on the chart, the AUD/USD would
eventually fall as well. (Learn more in A Forex Trader\'s View Of The Aussie/Gold Relationship.)

This connection between interest rate differentials and currency rates is not unique to the
AUD/USD; the same sort of pattern can be seen in USD/CAD, NZD/USD and the GBP/USD. Take a
look at the next example of the interest rate differential of New Zealand and U.S. five-year bonds
versus the NZD/USD.

Figure 2
The chart provides an even better example of bond spreads as a leading indicator. The
differential bottomed out in the spring of 1999, while the NZD/USD did not bottom out until the
fall of 2000. By the same token, the yield spread began to rise in the summer of 2000, but the
NZD/USD began rising in the early fall of 2001. The yield spread topping out in the summer of
2002 may be significant into the future beyond the chart. History shows that the movement in
interest rate difference between New Zealand and the U.S. is eventually mirrored by the
currency pair. If the yield spread between New Zealand and the U.S. continued to fall, then one
could expect the NZD/USD to hit its top as well.

Other Factors of Assessment

The spreads of both the five- and 10-year bond yields can be used to gauge currencies. The
genereal rule is that when the yield spread widens in favor of a certain currency, that currency
will appreciate against other currencies. But, remember, currency movements are impacted not
only by actual interest rate changes but also by the shift in economic assessment or plans by a
central bank to raise or lower interest rates. The chart below exemplifies this point.
Figure 3

According to what we can observe in the chart, shifts in the economic assessment of the Federal
Reserve tend to lead to sharp movements in the U.S. dollar. The chart indicates that in 1998,
when the Fed shifted from an outlook of economic tightening (meaning the Fed intended to
raise rates) to a neutral outlook, the dollar fell even before the Fed moved on rates (note on Jul
5, 1998, the blue line plummets before the red one). The same kind of movement of the dollar is
seen when the Fed moved from a neutral to a tightening bias in late 1999, and again when it
moved to an easier monetary policy in 2001. In fact, once the Fed just began considering
lowering rates, the dollar reacted with a sharp sell-off. If this relationship continued to hold into
the future, investors might expect a bit more room for the dollar to rally.

When Using Interest Rates to Predict Currencies Will Not Work

Despite the tremendous amount of scenarios in which this strategy for forecasting currency
movements does work, it is certainly not the Holy Grail to making money in the currency
markets. There are a number of scenarios in which this strategy may fail:

Impatience
As indicated in the examples above, these relationships foster a long-term strategy. The
bottoming out of currencies may not occur until a year after interest rate differentials may
have bottomed out. If a trader cannot commit to a time horizon of a minimum of six to 12
months, the success of this strategy may decrease significantly. The reason? Currency
valuations reflect economic fundamentals over time. There are frequently temporary
imbalances between a currency pair that can fog up the true underlying fundamentals
between those countries.
Too Much Leverage
Traders using too much leverage may also not be suited to the broadness of this strategy.
Since interest rate differentials tend to be fairly small, traders accustomed to using leverage
may want to use it to increase. For example, if a trader used 10 times leverage on a yield
differential of 2%, it would turn 2% into 20%, and many companies offer up to 100 times
leverage, tempting traders to take a higher risk and attempt to turn 2% into 200%. However,
leverage comes with risk, and the application of too much leverage can prematurely kick an
investor out of a long-term trade because he or she will not be able to weather short-term
fluctuations in the market.

Equities Become More Attractive

The key to the success of yield-seeking trades in the years since the tech bubble burst was
the lack of attractive equity market returns. There was a period in early 2004 when the
Japanese yen was soaring despite a zero-interest policy. The reason was that the equity
market was rallying, and the promise of higher returns attracted many underweighted funds.
Most large players cut off exposure to Japan over the previous 10 years because the country
faced a long period of stagnation and offered zero interest rates. Yet, when the economy
showed signs of rebounding and the equity market began to rally once again, money poured
back into Japan regardless of the country\'s continued zero-interest policy. This
demonstrates how the role of equities in the capital flow picture could reduce the success of
bond yields forecasting currency movements.
Risk Environment
Risk aversion is an important driver of forex markets. Currency trades based on yields tend
to be most successful in a risk-seeking environment and least successful in a risk-averse
environment. That is, in risk-seeking environments, investors tend to reshuffle their
portfolios and sell low-risk/high-value assets and buy higher-risk/low-value assets. Riskier
currencies - those with large current account deficits (which you can learn more about here)
- are forced to offer a higher interest rate to compensate investors for the risk of a
depreciation that is sharper than the one predicted by uncovered interest rate parity. The

higher yield is an investor\'s payment for taking this risk. However, in times when investors
are more risk averse, the riskier currencies - on which carry trades rely for their returns - tend
 to depreciate. Typically, riskier currencies have current account deficits and, as the appetite
for risk wanes, investors retreat to the safety of their home markets, making these deficits
harder to fund. It makes sense to unwind carry trades in times of rising risk aversion, since
adverse currency moves tend to at least partly offset the interest rate advantage.
Many investment banks have developed measures of early warning signals for rising risk
aversion. This includes monitoring emerging-market bond spreads, swap spreads, high-yield
spreads, forex volatilities and equity-market volatilities. Tighter bond, swap and high-yield
spreads are risk-seeking indicators while lower forex and equity-market volatilities indicate
risk aversion.

Conclusion
Although there may be risks to using bond spreads to forecast currency movements, proper
diversification and close attention to the risk environment will improve returns. This strategy
has worked for many years and can still work, but determining which currencies are the
emerging high-yielders versus which currencies are the emerging low-yielders may shift with
time.

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Related Terms
NZD (New Zealand Dollar) Definition
The New Zealand Dollar (NZD) is the currency abbreviation for the currency of New Zealand. more

AUD/USD (Australian Dollar/U.S. Dollar) Definition

The AUD/USD is the abbreviation for the currency cross of Australia and the United States. It is the fourth
most traded currency, and is highly correlated with commodity prices. more

Currency Carry Trade Definition

A currency carry trade is a strategy that involves using a high-yielding currency to fund a transaction with
a low-yielding currency. more

AUD

AUD is an abbreviation for the Australian dollar, also known as the Aussie dollar, or simply the Aussie.
more
What the Net Interest Rate Differential (NIRD) Tells Us
In international markets, the difference in the interest rates of two distinct economic regions. If a trader is
long on the NZD/USD pair, he or she owns the New Zealand currency and borrows the US currency. more

NZD/USD (New Zealand Dollar/U.S. Dollar) Definition

The NZD is the currency of New Zealand. Factors such as general market sentiment and dairy prices are
two factors that can change its value. more

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