Bond Spreads and Forex Markets​ (part one)

The two-sided strong relationship between currencies and bond spread (e.g. the difference between countries’ interest rates) is well-know. The forex market and the currencies affect the monetary policy decisions by central banks, and, conversely, monetary policy decisions impact the price of currencies. For instance, currency prices affect inflation, and inflation is the main macroeconomic indicator observed by central banks. Policy makers exploit this relationship to effectively manage their monetary policies. By understanding and observing these relationships and their patterns, investors take their trading decisions, to predict and capitalize on the movements of currencies. ​
Let’s provide a useful example. Many years ago, the Federal Reserve has brought fed funds below 2.0% threshold and hinted the interest rates could go even lower. Many international investors started to invest elsewhere, in search of higher yields. Australia was a country which had the same risk factor as the U.S., but which offered interest rates in excess of 5.0%. This is why the country started to attract global investors and, in turn, increased assets denominated in the Australian dollar. ​

The large spread between U.S. and Australian interest rates incentivised carry trade strategies, an arbitrage strategy that takes advantage of the interest rate spreads between economies, while aiming to benefit from the general direction or trend of currency pairs. This strategy involves buying one currency and funding it with another. The most freqently 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).

However, undertaking a carry-trade strategy is not easy, especially for little retail investors, who should continuously move money between bank accounts around the world. The retail spread on exchange rates can be higher than the yields obtainable with the carry trade. This is why this strategy could reveal not profitable. Otherwisw, there are some other categories of investors (e.g. investment banks, hedge funds, and institutionals) who can access global markets and exploit low spreads. Unlike the retail investors, they can shift money around the world, earning the highest yields, thanks to the lowest sovereign risk.

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