Bonds are a form of dept instrument used by large companies, governments and multinational organisations to access low rates of interest on funds they need to borrow in return for a fixed rate on their principal.
Let’s say you own a government bond. If the government has taken a bond, essentially it borrowed money from you,
Now, you might be thinking it sounds pretttyyyy similar to Stocks.
The main difference is the fact that when you borrow a bond, you will have a predetermined set date by when you need to pay the money back.
This will usually consist of payments at a specified rate of return, also known as the bond yield, at certain time intervals.
These payments are also known as coupon payments.
Bond yield is the interest paid to the bond-holder after the maturity period while the bond price is the sum of money the bondholder pays for the actual bond.
It is important to note that bond prices and bond yields are inversely correlated.
This therefore means that when bond prices rise, bond yields fall and when bond prices fall, bond yields rise.
Below is a mini illustration to help you remember this inverse correlation.
Now, let’s get to the core of this article and talk about the bonds relation to the Forex market.
Bond yields serve as an indicator of the strength of a specific country’s stock market, which increases the demand for the country’s currency.
In simple terms, this means that when the bond yields fall, it shows a slow down in the economy and therefore low currency value.
This prompts the Central bank to increase interest rates, and high interest rates mean currency appreciation.
For instance, the United States bond yields gauge the performance of the United States stocks market, and therefore reflects the demand for USD.
Let’s talk examples.
The demand for bonds generally rises when the stock market becomes riskier.
The uncertainty in the stock market drives the bond prices higher and, by virtue of their inverse relationship, pushes bond yields down.
As more and more traders sail away from stocks and other risky investments, increased demand for ‘less-risky-instruments’ like U.S. bonds and the safe-haven USD pushes their prices UP.
What are bond spreads and how does it correlate with Forex
Bond spread can be defined as the difference between two countries’ bond yields.
By monitoring these bond spreads as well as interest rates, traders can get an idea where currency pairs are headed.
A picture speaks a thousands words so let’s see what we mean by that on a chart by putting the AUD/USD side by side with the bond spread between Australia and United States.
You can clearly see that the bond between the given 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.
Can you see how the bond rose from 0.5 to 1.0 from 2002 to 2004?
And at the same time AUD/USD rose almost 50%, rising from 0.5 all the way to 0.7.
And then the same thing happened in 2007 and the bond rose from 1 to 2.5, whilst the AUD/USD rose from 0.69 to nearly 1.00
That’s about 2,000 pips!
Not too bad, right?
However, when the 2008 recession came along and all the major central banks started to cut their interest rates, AUD/USD went from the 0.9 handle back down to 0.7.
Why did it happen?
Because traders tried to make the most of carry trade so when bond spreads between the Aussie bonds and U.S. Treasuries were increasing, traders loaded up on their long AUD/USD positions.
We know that if this was your first time hearing about the Bonds Market, it might have seem pretty confusing.
But don’t let this put you off! Just like with everything else, it gets easier in time!
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