As we touched on in the previous lesson, rates of return can often serve as a reliable indicator of currency price movements.
When the bond spread between the given economies rises, the currency with the higher bond yield will normally appreciate against the other.
Fixed income securities are debt instruments that pay a fixed amount of interest to investors until their maturity date.
Now, economies of countries that offer higher returns on their fixed income securities, therefore, attract more investors than countries that offer lower returns on their fixed income market.
Let’s use UK bonds (Gilts) and European bonds (Euribors) as an example.
If Euribor were to offer a higher rate of return compared to Gilts, investors would be super excited to put their money into the EU fixed income market rather than Gilts.
This would therefore mean that EUR would strengthen compared to GBP.
However, if the tables turned, and Gilts were to offer a lower rate of return, investors would be discouraged from investing in them and they would invest in another higher-yielding asset instead.
This would therefore mean that EUR would weaken compared to GBP.
We could compare the yields on the fixed income securities of Korea and Russia and use the differentials to predict the behaviour of the real and the ruble.
We could do this with any and every fixed-income security and predict their future movement.
IMPORTANT: REMEMBER IF YOU ARE COMPARING BONDS, USE THE SAME TERM TO MATURITY (E.G. 3-YEAR SWISS BONDS TO 3-YEAR CANADIAN BONDS) OR YOUR ANALYSIS WILL BE OFF.
If you want to look into bonds and these correlations, even more, check out the following websites.
They’re like the holy grail of Bonds.
Now, there are hundreds of different bonds around the world but we don’t want to confuse you too much talking about all of them.
So for now, you might want to stick to bonds of countries that are a part of the majors.
We have listed them down for you along with their nicknames so it’s easier to remember!
You’re welcome! 😉
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