Bond Spreads: A Leading Indicator For Forex

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. "or instance, a stronger currency helps to hold down inflation, while a weaker currency will boost inflation. #entral banks take advantage of this relationship as an indirect means to effectively manage their respective countries' monetary policies. $y understanding and observing these relationships and their patterns, investors have a window into the currency market, and thereby a means to predict and capitali%e on the movements of currencies. What Does Interest Have to Do With Currencies? To see how interest rates have played a role in dictating currency, we can look to the recent past. &fter the burst of the tech bubble in '(((, traders went from seeking the highest possible returns to focusing on capital preservation. $ut since the ).*. was offering interest rates below '+ (and going even lower , many hedge funds and those who had access to the international markets went abroad in search of higher yields. &ustralia, with the same risk factor as the ).*., offered interest rates in e,cess of -+. &s such, it attracted large streams of investment money into the country and, in turn, assets denominated in the &ustralian 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 .apanese yen and the *wiss franc because of their countries' e,ceptionally low interest rates. The popularity of the carry trade is one of the main reasons for the strength seen in pairs such as the &ustralian dollar and the .apanese yen (&)/0.12 , the &ustralian dollar and the ).*. dollar (&)/0)*/ , the 3ew 4ealand dollar and the ).*. dollar (34/0)*/ , and the ).*. dollar and the #anadian dollar ()*/0#&/ . (5earn more about the carry trade in The Credit Crisis And The Carry Trade and Currency Carry Trades Deliver. 6owever, it is difficult for individual investors to send money back and forth between bank accounts around the world. The retail spread on e,change rates can offset any additional yield they are seeking. 7n the other hand, investment banks, hedge funds, institutional investors and largecommodity trading advisors (#T&s generally have the ability to access these global markets and the clout to command low spreads. &s 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, e,change rates move based upon changes in money flows. The Insight for Investors 8ndividual investors can take advantage of these shifts in flows by monitoring yield spreads and the e,pectations for changes in interest rates that may be embedded in those yield spreads. The following chart is just one e,ample of the strong relationship between interest rate differentials and the price of a currency.

3otice how the blips on the charts are near9perfect mirror images. The chart shows us that the five9year yield spread between the &ustralian dollar and the ).*. dollar (represented by the blue line was declining between :;<; and :;;<. This coincided with a broad sell9off of the &ustralian dollar against the ).*. dollar. When the yield spread began to rise once again in the summer of '(((, the &ustralian dollar responded with a similar rise a few months later. The '.-+ spread advantage of the &ustralian dollar over the ).*. dollar over the ne,t three years equated to a =>+ rise in the &)/0)*/. Those traders who managed to get into this trade not only enjoyed the si%able capital appreciation, but also earned the annuali%ed interest rate differential. Therefore, based on the relationship demonstrated above, if the interest rate differential between &ustralia and the ).*. continued to narrow (as e,pected from the last date shown on the chart, the &)/0)*/ would eventually fall as well. (5earn 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 &)/0)*/? the same sort of pattern can be seen in )*/0#&/, 34/0)*/ and the @$10)*/. Take a look at the ne,t e,ample of the interest rate differential of 3ew 4ealand and ).*. five9year bonds versus the 34/0)*/.

The chart provides an even better e,ample of bond spreads as a leading indicator. The differential bottomed out in the spring of :;;;, while the 34/0)*/ did not bottom out until the fall of '(((. $y the same token, the yield spread began to rise in the summer of '(((, but the 34/0)*/ began rising in the early fall of '((:. The yield spread topping out in the summer of '((' may be significant into the future beyond the chart. 6istory shows that the movement in interest rate difference between 3ew 4ealand and the ).*. is eventually mirrored by the currency pair. 8f the yield spread between 3ew 4ealand and the ).*. continued to fall, then one could e,pect the 34/0)*/ to hit its top as well. Other Factors of Assessment The spreads of both the five9 and :(9year 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. $ut, 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

e,emplifies this point. &ccording to what we can observe in the chart, shifts in the economic assessment of

the "ederal Aeserve tend to lead to sharp movements in the ).*. dollar. The chart indicates that in :;;<, when the "ed shifted from an outlook of economic tightening (meaning the "ed intended to raise rates to a neutral outlook, the dollar fell even before the "ed moved on rates (note on .ul -, :;;<, the blue line plummets before the red one . The same kind of movement of the dollar is seen when the "ed moved from a neutral to a tightening bias in late :;;;, and again when it moved to an easier monetary policy in '((:. 8n fact, once the "ed just began considering lowering rates, the dollar reacted with a sharp sell9off. 8f this relationship continued to hold into the future, investors might e,pect a bit more room for the dollar to rally. When Using Interest Rates to Predict Currencies Will Not Wor /espite the tremendous amount of scenarios in which this strategy for forecasting currency movements does work, it is certainly not the 6oly @rail to making money in the currency markets. There are a number of scenarios in which this strategy may fail! !patience &s indicated in the e,amples above, these relationships foster a long9term strategy. The bottoming out of currencies may not occur until a year after interest rate differentials may have bottomed out. 8f a trader cannot commit to a time hori%on of a minimum of si, to :' months, the success of this strategy may decrease significantly. The reasonB #urrency 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 "uch #evera$e Traders using too much leverage may also not be suited to the broadness of this strategy. *ince interest rate differentials tend to be fairly small, traders accustomed to using leverage may want to use it to increase. "or e,ample, if a trader used :( times leverage on a yield differential of '+, it would turn '+ into '(+, and many companies offer up to :(( times leverage, tempting traders to take a higher risk and attempt to turn '+ into '((+. 6owever, leverage comes with risk, and the application of too much leverage can prematurely kick an investor out of a long9term trade because he or she will not be able to weather short9term fluctuations in the market. %&uities 'eco!e "ore Attractive The key to the success of yield9seeking trades in the years since the tech bubble burst was the lack of attractive equity market returns. There was a period in early

'((C when the .apanese yen was soaring despite a %ero9interest policy. The reason was that the equity market was rallying, and the promise of higher returns attracted many underweighted funds. Dost large players cut off e,posure to .apan over the previous :( years because the country faced a long period of stagnation and offered %ero interest rates. 2et, when the economy showed signs of rebounding and the equity market began to rally once again, money poured back into .apan regardless of the country's continued %ero9interest policy. This demonstrates how the role of equities in the capital flow picture could reduce the success of bond yields forecasting currency movements. Ris( %nviron!ent Aisk aversion is an important driver of fore, markets. #urrency trades based on yields tend to be most successful in a risk9seeking environment and least successful in a risk9averse environment. That is, in risk9seeking environments, investors tend to reshuffle their portfolios and sell low9risk0high9value assets and buy higher9risk0low9 value assets. Aiskier currencies 9 those with large current account deficits (which you can learn more about here 9 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. 6owever, in times when investors are more risk averse, the riskier currencies 9 on which carry trades rely for their returns 9 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. 8t 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. Dany investment banks have developed measures of early warning signals for rising risk aversion. This includes monitoring emerging9market bond spreads, swap spreads, high9yield spreads, fore, volatilities and equity9market volatilities. Tighter bond, swap and high9yield spreads are risk9seeking indicators while lower fore, and equity9market volatilities indicate risk aversion. Conclusion &lthough there may be risks to using bond spreads to forecast currency movements,

properdiversification 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 high9yielders versus which currencies are the emerging low9yielders may shift with time.