The correlation between sovereign bonds and currencies

Sometimes forex traders are used to trading not only currency pairs but also sovereign bonds in their daily acitivity. If you have a portfolio consisting of both currencies and sovereign bonds, you need to understand what relationship exists between the two, in order to plan a profitable trading strategy. The first thing to keep in mind is that sovereign bond yields are an excellent indicator of the strength of a nation’s economy, which increases the demand for domestic currency. For example, U.K. gilt yields capture the strength of the British economy, thereby influencing demand for the sterling. The second thing to consider is that there is a well-known trade-off between bonds and stocks, since the demand for the former usually increases when the demand for the latter decreases. And viceversa. The so-called “flight to safity” effect pushes bond prices upwards and, by virtue of this trade-off, pushes down sovereign bond yields.

As more and more traders sell stocks, the increased demand for less risky assets, such as British sovereign bonds and the pound, pushes prices higher. Sovereign bond yields are a good proxy of how to predict the performance of a country’s interest rates. Let’s focus again on the U.K. 10-year sovereign bond. A rising yield is sterling bullish. A drop in yields is sterling bearish.

It is important to know the underlying dynamics that explains why the bond yield goes up or down. It can be based on interest rate expectations or it can be based on market uncertainty and the “flight to safity” effect with money being stolen from risky assets, such as stocks, to be invested in less risky assets, such as sovereign bonds. After understanding how rising sovereign bond yields cause the appreciation of the domestic currency, you probably want to find out how this relationship can be profitably applied to forex trading, with the aim of pairing a strong currency with a weak one, comparing first their economies. The analysis of “bond spread” provides an answer to this question.

Last week, we started to discuss about the relation between sovereign bonds and currencies in forex markets. One thing to bear in mind is that as the bond spread between two economies widens, the currency of the country with the higher bond yield appreciates against the other currency of the country with the lower bond yield. For example, this is what happened with the Aussie price action and the bond spread between Australian and U.S. 10-year sovereign bonds from January 2000 to January 2012. When the bond spread rose from 0.50% to 1.00% from 2002 to 2004, the Aussie rose almost +50,0%, from 0.5000 to 0.7000. The same happened in 2007. When the bond differential rose from 1.00% to 2.50%, the Aussie rose from 0.7000 to just above 0.9000, granting a 2,000 pips-gain.

Everything changed with the 2008 Great Recession, when all the major central banks started to cut their interest rates. On forex markets, the Aussie fell from the 0.9000 handle back down to 0.7000, as traders took advantage of carry trades. When bond spreads were increasing between the Aussie bonds and U.S. Treasuries, traders went long on the Aussie, to take advantage of carry trade. However, once the Reserve Bank of Australia followed the U.S. Federal Reserve, engaging in a rate-cut race, bond spreads began to tighten, and traders reacted by going short on the Aussie, as going long was no longer a profitable strategy.

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