Bond Spreads and Forex Markets​ (part two)

Forex traders can take advantage of carry trade strategies by observing yield spreads and the expectations for changes in interest rates embedded in those yield spreads. ​
For example, the spread between the AUD and the USD was declining between 1989 and 1998, due to a massive sell-off of the AUD against the USD. ​Then, the yield spread began to rise once again in the summer of 2000, and the AUD reacted with a rise, a few months later. The 2.5% spread advantage of the AUD over the USD over the next three years translated into a +37.0% gain in the AUD/USD. Forex traders who had undertaken a carry trade strategy enjoyed both a sizable capital appreciation, and the annualized interest rate differential gain.

What can we learn fron this example? The empirical evidence shows that if the interest rate differential between two countries narrows, according to rational expectations, the exchange rate would eventually fall as well. The relationship between interest rate differentials and currency rates has been observed also for other currency pairs: USD/CAD, NZD/USD and the GBP/USD.
Usually, the spread of 10-year bond yields is used by forex traders as a proxy to forecast currencies’ trends. A rule of the thumb says that when this benchmark widens in favor of a certain currency, that currency will appreciate against other currencies. Nevertheless, currency trends depends not only by actual interest rate changes, but also by changes in economic expectations or in central bank’s forward guidance. ​
Changes in the economic assessment or in the forward guidance on interest rates and/or money supply by central banks provoke strong effects on currencies. In 1998, for example, the Fed abandoned an outlook of economic tightening (e.g. to raise rates) to a neutral one. The dollar fell even before the Fed actually hicked rates. The same movement of the dollar was observed when the Fed departed from a neutral to a hawkish monetary stance in late 1999, and again when it moved to a more dovish stance in 2001. Once the Fed just announced to be willing to lower fed funds, the USD was massively sold-off by forex traders.

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