With all the ruckus in the market lately about bonds, yields and the impact they have on the currency market I did some research into what bonds are, how they work and how they correlate with the forex market. What at first seemed like a very complicated subject seems pretty straight forward. I have included some links for further reading at the end of the article should you wish to go and do some further research yourself. Should anyone have any feedback please do leave a comment below as I welcome any thoughts, questions or corrections. Enjoy 🙂
What is a bond
The government or a publicly listed company uses bonds to raise money by borrowing it from market participants (the lender) and in return paying the lender (market participant) interest (yield) on the loan until the term of the loan expires when the principal (original loan amount) is paid back in full. So basically you and I could lend money to the government or to a company like Ford (used by Wayne in many examples) and in return receive interest (this is called the yield) on our loan, usually every six months (called coupon payments), until the term of the loan expires (when the bond reaches maturity) and at such time receive the principal (original loan amount) back in full. Buying bonds is a safe way to invest as it is the closest an investor is going to get to a guaranteed return on investment (the bond issuer must make coupon payments according to the yield and pay back the principal when the bond matures) with limited risk to their investment as compared to the stock market or commodities for example. As a forex trader we focus on the fluctuation of the 10 year bond – so the US 10 Year T-Note or the German 10 Year Bund or the UK 10 Year Gilt and the correlation with the currency market.
When do traders buy and sell bonds
One example of when an investor would buy a government bond are risk off market conditions where investors want to get their money into a safe-haven or when the central bank of that country selling the government bond is likely to cut interest rates in the near future. One example of why an investor would sell a government bond is when market conditions are risk on and investors want to get their money into riskier assets that pay a larger return compared to the yield on the bond they own or when the central bank of that country is likely to increase interest rates in the near future.
How interest rates impact yield
Let’s look at a completely hypothetical and very simplified example – let’s say you bought a $1,000 10 year T-Note with a yield of 1.5%. – this means you paid $985 for the $1,000 10 year T-Note ($1,000 less 1.5%). You will now receive 1.5% interest on your bond over the next ten years and in ten years, when the bond matures, you will be paid back the $985 you lent the government. Note that the government will never pay you more than $1,000 for this bond – this value is called par.
Let’s say the very next day the FOMC announced that they were going to increase the interest rate by x% in the next six months. Suddenly all the owners of bonds quickly realise that the value of their bond is going to be less because investors that buy bonds in six months will earn a greater yield because of the higher interest rate.
A fair market price needs to be established in the open market between sellers and buyers so some calculations are done and the market works out that the yield on the 10 year T-Note will be 3% should the FOMC increase rates by x% as they said they would. Bond owners have a problem – they can’t sell their current bonds at breakeven because buyers know that the 1.5% yield sellers are offering is far less than the 3% yield they’ll get when rates increase so the sellers then decide that they need to decrease the price of the bond which they bought for $985 (par less 1.5%) to $970 (par less 3%) so that the bond is effectively worth the same as if it was bought at the new interest rate.
In the following weeks, more data is released out of the US along with FOMC speakers confirming that a rate hike is highly likely – suddenly more bond sellers enter the market, bond prices drop further and yields go up. The US Dollar gets stronger and safe havens like the Yen get weaker as all of this indicates a strong US economy to investors. So while the FOMC have not yet increased the interest rate, taking a look at the yields in the bond market it’s as if it has already happened.
Of course, if anything happened that indicated a rate hike was unlikely – poor data or a FOMC member with dovish comments – buyers would get into the market, bond prices would increase and yields would go down. This would result in US Dollar weakness and safe havens like the Yen would get strong. Think of it this way – when bonds go up money is moving from that countries bank into the bond market and when bonds are going down money is moving from the bond market into that countries bank.
So, while the example is very oversimplified and the speed at which bond prices would increase as mentioned in the example has been slightly exaggerated the point of the exercise is to help readers understand the correlation between bonds, yields and the currency market.
If a trader is observing the movement in the market of the 10Y T-Note and it is going down this means yields are going up and one would expect to see US Dollar strength and Yen weakness. Of course the opposite is also true – a rising 10Y-T-Note would mean yields are going down and if observed one would expect to see a weaker US Dollar and stronger Yen.
This does not only apply to the US Dollar, it applies to all currencies. Recently we have seen strength in the Euro, even against the strong US Dollar, what caused this? 10 year Bunds prices were dropping which means a higher yield and a stronger Euro currency.
To quote Brad Pitt playing Billy Beane in Moneyball, “How can you not be romantic about baseball?” I look at the currency markets every day and I think to myself – how can you not be romantic about forex. Millions of traders buying and selling in an open market, trillions of dollars exchanging hands every day, under constantly changing risk events, in an ever-evolving global economy with so many moving parts and yet, the whole remains in synch and correlated with the sum of its parts. Yes, there are anomalies though nothing exists in isolation because there is always cause and effect and as a currency trader it is our job to dissect, investigate, discover and analyse so that our next move will be better than our last.
While observing bonds and the correlation to the currency market does not provide us with a crystal ball or holy grail, and it certainly does not stand alone, it does give us more information to include in our decision making process so that we can determine our bias and better identify the most appropriate conditions to enter a trade. The important thing for me is not just observing the US10Y 4H chart and knowing when to go long USDJPY but rather identifying the cause of investors buying or selling bonds ahead of time and understanding the overall fundamental trend for that particular country and central bank.