Very few traders realize it, but bond spreads have an immense value when trading Forex on a daily/weekly basis. In this guide, we’ll show how you can use this technique to improve your Forex trading.
Firstly, let’s see what ‘spread’ means in this context. Usually, in Forex, the spread is the difference between the bid and ask prices. However, here we are concerned with a different kind of spread: the bonds yields spread. For example, if US 10y bonds yield is 2%, and UK 10y bond yield is 1.5%, the spread would be 0.5 percentual points. Higher spreads suggest that interest rates are higher in a country relative to another. As we will see, these spreads can be valuable in trading.
How do Bonds Spreads affect the Forex market?
Now that we know what the bonds spread is, it’s important to understand how spreads influence the Forex market. This relation depends on one main factor – interest rates. Interest rates are the basis of any bond, and higher interest rates will mean higher bond yields. Interest rates can affect the Forex market because of 2 main reasons:
1. Institutional and Private Investors
Yields are dependent on the interest rate defined by Central Banks. If the Fed or the ECB decide to increase interest rates, bond yields from the respective companies will also increase. This happens because bonds are dependent on the interest rate from the country where they are issued. A rise in interest rates means bonds will pay a higher interest, i.e., have a higher yield. Investors will, therefore, get higher returns.
When interest rates are higher in country A relative to country B, bonds from country A are more attractive. Investors will prefer to put their money in these bonds since they pay higher coupons.
To buy bonds, investors will need to exchange their currency for the currency in which bonds are traded. So, the currency with higher yield bonds will have a higher demand.
2. Central Banks
As already said, the price of bonds depends on the interest rates defined by central banks. According to their monetary policies, central banks buy or sell bonds in order to achieve the desired interest rate. To raise the interest rate, central banks sell bonds, increasing supply and reducing bonds prices. Bond yields and their prices go in opposite directions so, when central banks raise interest rates, prices fall and yields rise. In this sense, when central banks sell bonds, they are withdrawing money out of the economy. This will make the currency appreciate. The reduction of money in circulation makes each unit to worth more.
Both arguments explain the positive correlation between bonds spreads and forex. From one side, higher interest rates will attract more investors. These investors will increase the demand for the currency in which the bond is traded. On the other hand, higher interest rates mean Central Banks are selling bonds, which reduces the supply of money in the economy. The two will contribute to an appreciation of the domestic currency.
Simply put, between two countries, the currency of the country with higher interest rates tends to appreciate.
Looking at some examples…
Traders can expect an appreciation in the domestic currency after a rise in interest rates. We can see this positive correlation between bond spreads and forex in the following charts.
Although the correlation between bonds and spreads is positive in the overall picture, there are periods where both diverge from each other. Those divergence periods are annotated in red.
USD/JPY vs US 10Y / JP 10Y Yield Spreads
In this chart, it’s possible to see a very close correlation between US bonds and Japanese bonds spreads and USD/JPY. However, there are two main periods we want to highlight:
Divergence (in red): During the period from December 2011 to April 2016, there was only one period in which the positive correlation did not stand. The period signaled in red shows a high volatility in bond spreads while the pair traded relatively flat. This is a divergence.
Spreads leading USDJPY (in yellow): we see how the major increase in spreads that happened in August 2013 only affected the forex market one year later. Actually, it’s very common to see this lag correlation, usually with spreads usually leading the pair between 2 and 10 months.
GBP/USD vs UK 10Y / US 10Y Yield Spreads
Spreads leading Pair (in yellow): We can see yet again, in this chart, how a major drop in the forex market follows a major drop in spreads only months later. Both charts show how, very often, spreads movements lead the Forex pair’s movement.
Divergences (in red): In 1 and 3, GBP/USD rose while bonds went down, while in 2 and 4, the contrary happened.
How can traders benefit from this relationship?
Traders may profit from the above-mentioned correlation in two main ways:
1. Through carry trade. It involves borrowing in the country that has a lower interest rate and buying a bond in the country with the highest. As long as the exchange rate remains the same, the bond spread is the profit. However, this strategy can be risky, since the movements in the Forex pair will ultimately compensate for that differential. In practice, this has to be implemented within a hedging strategy.
2. Divergences between spreads and the Forex pair. We know that spreads usually lead the Forex pair by some months, so when they diverge, we know that the pair’s movement is nearly ending. For example, if GBP/USD is rising, but the bonds spreads are falling for some months already, you should be getting ready to short GBP/USD.
Resources
All the data collected for the research was extracted from www.investing.com.
Conclusion
The relationship between bonds spreads and forex is a very useful analysis to forecast movements in certain pairs. However, traders should do a more broad analysis of the market before entering a position. In the article Intermarket Relationships in Forex, we explain how other factors such as the price of commodities and stocks also affect the Forex market.
There are various relationships between different financial markets. These intermarket relationships are important in Forex trading because, by understanding the different correlations, you’ll be able to take advantage of them to capitalize gains and hedge positions. In this guide, we will focus on the securities related to the various Forex pairs.
Correlation measures the relatedness between securities. I.e., if one rises when the other drops, if they rise at the same time, etc. A perfect correlation is equal to 100% – both securities increase or decrease by the same proportion. The higher the correlation, the stronger the relation between two assets.
Gold and USD
Gold is one of the most traded commodities in the world. Because this precious metal has an intrinsic value, it’s considered to be a “safe haven” in times of uncertainty and bearishness. Gold relates to three major currencies – the USD, the AUD and the CHF.
Firstly, let’s see the relationship between gold and USD. As the commodity’s price is in US dollars, a rise in the dollar makes it more expensive for non-US investors to buy gold. If, say, a European investor wants to buy gold, he/she should first exchange his euros for dollars. If the dollar appreciated against the euro, more euros would be necessary to buy gold. In this sense, this investor will see the price of gold become relatively more expensive as dollar appreciates.
So, the USD index/GOLD relationship is an inverse relation – when one rises, the other decreases. An increase in USD makes gold more expensive, which, according to microeconomics, reduces demand for the commodity. The decrease in gold’s demand drives down the price per ounce – this is called a negative correlation. In the graph below it is possible to see that to a lower dollar value corresponds a higher price of gold and vice-versa.
Correlation USD index – GOLD 1995-2016 (Source: Macrotrends)
Furthermore, IMF estimates nearly 50% of the changes in gold prices are due to movements of the US dollar.
GOLD-AUD & GOLD-CHF
The correlation between gold and AUD is positive. This is because Australia is one of the major exporters of gold and so, if the price of gold increases, Australian exports increase, contributing to the expansion the economy. The expansion of the economy contributes to an increase in foreign investment in Australia, which means the demand for Aussie dollars will increase.
Historically, AUD has an 80% correlation with gold.
AUD/USD – Gold (Source: Bloomberg)
Gold and CHF also have a positive correlation. One reason for this is that both assets are inflation-hedging safe-havens, which means they both appreciate with a rise in inflation. In times of uncertainty and selloff of currencies like the dollar, investors usually put their money into these assets. Besides having the same status as “safe-havens,” nearly 25% of Switzerland money is backed by gold reserves, the reason why CHF rises when gold appreciates.
Oil and CAD, NOK
Oil correlates positively with CAD and NOK because Canada and Norway are two major oil producers.
Canada, besides being one of the major oil producers, is the biggest exporter to the US, with around 85% of its exports going to its down south neighbor. As oil is priced in US dollars, oil exports have a major impact on the foreign exchange earnings in Canada. When oil prices increase, the amount of US dollars earned by Canada through exports will be higher, and therefore the supply of US dollars will be high relative to the supply of Canadian dollars. This results in an increase in the value of the CAD against USD.
You can take advantage of this relation by buying CAD/USD when oil price is rising or, instead, short the pair when it is falling. On a daily basis, the correlation can be less evident, but over the long-term, the value of CAD has shown to be sensitive to the price of oil. Below it is possible to see this close correlation. Notice that oil (green/red line) moves in the same direction as CAD/USD (blue line) most of the times, but usually the volatility of oil is much larger than of the currency.
The positive correlation between oil and CAD/USD was about 80% over the past 10 years.
CAD Index – Oil (Source: ProRealTime)
Norway is also one of the major oil exporters worldwide, even bigger than Canada. This means that, when oil prices go up, the foreign exchanges inflow in Norway will increase, increasing the supply of foreign currencies relative to NOK. The higher supply of foreign currencies relative to the supply of NOK drives up its price. However, although there are times which NOK/OIL correlation may surpass 90%, in other times it is less than 20%. This makes NOK not such a good proxy for oil prices as CAD. If Forex traders want to take advantage of a change in oil’s price, the best currency to look for should be the Canadian dollar.
Commodities and NZD
One particular currency that benefits from the rise in general commodities prices is the New Zealand Dollar. This happens because New Zealand has many natural resources and a large agricultural sector. In this sense, a lot of New Zealand exports’ revenues come from commodities’ sales. When prices of commodities rise, the exports (and, consequently, revenues) rise and the economy gets a boost, therefore increasing the value of NZD.
The proximity of New Zealand to Australia also makes New Zealand’s economy closely tied to Australia’s. This means that there is also a positive correlation between gold and NZD. When gold prices rise, Australia’s economy expands, and this influences its neighbor’s economy. And so, both AUD and NZD appreciate with the rise in the price of gold. AUD and NZD are closely correlated – an appreciation of NZD often matches in AUD.
In the chart below we can see a comparison between the CRB index (an index that measures the overall direction of commodities) and NZD/USD. Notice how the NZD/USD is positively related to the CRB Index – one increases when the other increases and vice versa.
NZD/USD – CRB Index (Source: Bloomberg)
Other Intermarket Relations in Forex
Some of the exotic currencies are also related to commodities. Below you can find out about some of these relationships.
Oil/Natural Gas and RUB
Russia is one of the largest oil producers and has the largest natural gas reserves in the world, so its economy is very dependent on the price of the two commodities. Valuation in prices of oil or natural gas is very often linked with an appreciation of the Russian ruble. Below it is possible to see the positive correlation between oil and RUB/USD.
RUB/USD – OIL (Source: Bloomberg)
Precious Metals and ZAR
South Africa is a big exporter of several precious metals. It’s the 11th largest exporter of gold in the world, the 2nd in palladium and the 1st in platinum. This makes the country’s currency, ZAR, too dependent on the price of these precious metals in the markets. An increase of their prices will give increase South Africa’s exports and give ZAR a boost. Hence, there is a positive correlation between ZAR and these precious metals.
African/South American Currencies and Agricultural Commodities
Plenty of agricultural commodities’ exports come from African or South American countries. The currencies’ of these countries are, therefore, highly exposed to fluctuations in commodities prices like soybeans (large exporters are Argentina and Brazil), wheat (Argentina), cocoa (Côte d’Ivoire and Ghana), corn (Brazil and Argentina) or sugar (Brazil). Despite some currencies showing a positive correlation with a particular commodity, major fluctuations in valuations are usually due to changes in commodities general prices.
How Currencies React to the Bond Market
The price of bonds depends on the current interest rates established by the central banks. To keep interest rates constant, central banks need to buy or sell bonds until reaching the desired interest rate. If a central bank wants to raise an interest rate, it simply sells bonds to increase the supply and lower the price of each bond. As bonds’ prices and interest rates have an inverse relationship, when bonds prices decrease, interest rates increase.
This buying and selling of bonds have a great impact in the Forex market. When a central bond is buying bonds, it’s injecting money into the economy, increasing the supply of the currency. On the other hand, when the central bank is selling bonds, it’s withdrawing money out of the markets. This is why the domestic currency appreciates when interest rates are raised. The reduction of money in circulation makes each unit of the currency to be worth more.
Traders can profit from different levels of interest rates in the various countries through carry trade. Carry trade involves borrowing in the country that has a lower interest rate and buying a bond in a country that has a higher interest rate. As long as the exchange rate between the two countries remains the same, the profit comes from the difference between interest rates (also called bond spreads). The relationship between bond spreads and the Forex market will be discussed in another article.
Stock Market and Domestic Currency
The relationship between the stock market and its domestic currency may be less intuitive to understand since different factors should be weighed.
- On the one hand, we can observe a positive correlation between the stock market of a country and its currency. This is because when the stock market is rising, more foreign investors want to invest in that stock market, therefore increasing the demand for the respective currency. This will contribute to the appreciation of the domestic currency.
The following chart shows the relation between EUR/USD and the Eurostoxx 50 in the last month. It’s visible the positive relationship between both assets – they go in the same direction.
EUR/USD – Eurostoxx50 (Source: Bloomberg)
- On the other hand, an expansionary monetary policy may have a positive impact in the stock market. In this case, the central bank will decrease interest rates and buy sovereign bonds, injecting money into the economy to stimulate investment. Injecting money means increasing the supply of money, which will devalue the currency. In this case, the stock market is rising, but the value of the currency is falling – negative correlation.
The following chart presents the same assets but in a different timeframe. It is possible to observe how, on the right side, the EUR/USD (orange) decrease while the Eurostoxx50 (blue) rise – we have a negative correlation.
EUR/USD – Eurostoxx50 (Source: Bloomberg)
The Bottom Line
Before trading a pair, the trader should observe what the monetary policies of both countries are and how is the bond market. Don’t go long on a currency when the respective central bank is lowering interest rates or buying bonds. This policy increases the supply of money in the economy, depreciating its value. Inversely, the stock market rises with these expansionary policies because investors will prefer to invest in stocks instead of having lower returns from bonds.
Taking Advantage from Intermarket Relationships in Forex
To profit from these correlations, we look for confirmations and divergences. A confirmation happens when two related assets are moving in the same direction, while a divergence happens when they are moving in opposite directions.
Confirmation Example – Gold and AUD/USD
The next two charts show how gold prices preceded a breakout in the AUD/USD. Gold broke a medium-term support on 11th of November while AUD/USD only broke a support on the 17th of November. If you had spotted the depreciation of gold prices, you could have placed a sell order for AUD/USD near the support and profit from the breakout.
This is a clear case in which gold lead the AUD/USD movement. There was a confirmation when AUD/USD went in the same direction of gold and broke a medium term support.
As we could see from the above example, currencies don’t react to movements in other markets instantaneously. These correlations are usually stronger in the daily and upper timeframes.
Hedging
Traders can also benefit from correlations by hedging their positions. But what is hedging exactly?
Let’s imagine a trader who is currently long OIL. If this trader doesn’t have any other position, he’s fully exposed to oil’s variations. If he wants to decrease his level of risk, he may short CAD/USD. This way, if the price of oil increases, CAD will most likely appreciate. As CAD and OIL aren’t fully correlated (their correlation is not 100%), oil will probably appreciate more than CAD. This trader will, in this way, profit from the position in OIL and have a loss from his position in CAD/USD, but his profit will be bigger than his loss. That position leaves him relatively less exposed to oil’s fluctuations. A large drop in oil’s price will not hurt him so much since he is backed up by his position in the Forex market, that will give him a profit. The overall loss will be smaller.
Conclusion
Summing up, traders should not use intermarket relationships just to capitalize gains but also to hedge positions. Diversifying and managing risk are strategies that perform better over the long run. The correlations mentioned above can be used to reduce drawdowns and benefit from gains across markets, allowing traders to achieve higher returns with less risk.
Sources
Traders can find and analyze all these relations between markets in ProRealTime and Bloomberg. Both platforms offer a broad range of tools that allow to make comparisons between markets and to understand their dynamic.
