Chapter 22
Fundamental Strategy: Using Bond Spreads as a Leading Indicator for FX

Any trader can attest that interest rates are an integral part of investment decisions and can drive markets in either direction. FOMC rate decisions are the second most market moving release for currencies, behind nonfarm payrolls. The effects of interest rate changes have not only short-term implications, but also long-term consequences on the currency markets. One central bank's rate decision can affect more than a single pairing in the network of currencies. Yield differentials of fixed-income instruments such as Libor rates and 10-year bond yields can be used as leading indicators for currency movements. In FX trading, an interest rate differential is the difference between the interest rate of a base currency (appearing first in the pair) less the interest rate of the quoted currency (appearing second in the pair). Each day at 5pm EST, the close of the day for currency markets, funds are either paid out or received to adjust for interest rate differences. This is known as rollover. Understanding the correlation between interest rate differentials and currency pairs can be very useful particularly since it is the single most important driver of currency movements. In addition to monetary policy decisions, the future direction of rates along with the expected timing of rate changes is also critical to currency pair movements. The reason why it is important is because the majority of international investors are yield seekers. Large investment banks, hedge funds, and institutional investors have the ability access the global markets and actively shift funds from lower yielding assets to higher yielding assets.

Calculating Interest Rate Differentials and Following the Currency Pair Trends

The best way to use interest rate differentials for trading is by keeping track of one-month LIBOR rates and/or 10-year bond yields in Microsoft Excel. These rates are publicly available on websites such as Bloomberg.com. Interest rate differentials are then calculated by subtracting the yield of the second currency in the pair from the yield of the first. It is important to make sure that interest rate differentials are calculated in the order in which they appear for the pair. For instance, the interest rate differentials in GBPUSD should be the 10-year gilt rate minus the U.S. 10-year rate. For euro data, use data from the German 10-year bund. Form a table that looks similar to the one shown in Figure 22.1.

		German 10Yr	US 10	EZ-US			UK-US
Date	EURUSD	Yield	Year Yield	Yield Spread	GBPUSD	UK 10-Yr Yield	Yield Spread
1-Jan	1.2097	0.541	2.172	–1.631	1.5574	1.756	–0.1986
1-Feb	1.1293	0.302	1.642	–1.34	1.5060	1.33	0.176
1-Mar	1.1195	0.328	1,994	–1993.672	1.5431	1.796	–0.2529
1-Apr	1.0740	0.18	1,924	–1923.82	1.4822	1.576	–0.0938
1-May	1.1212	0.366	2.033	–1.667	1.5344	1.834	–0.2996

Figure 22.1 Yield Spread Table

After sufficient data are gathered, you can chart the currency pair values versus yields using a graph with two axes to see if there are any correlations or trends. The date should be used as the x-axis and currency pair price and interest rate differentials as the two y-axes. To fully utilize these data in trading, it is important to monitor the trend of interest rates differentials because they can be used as a guide for the future direction of the currency pair.

To fully appreciate the correlation between interest rates and currencies, let's take a look at a few examples. Figure 22.2 charts the EURUSD against the 10-year German bund and U.S. Treasury yield spread between June 2010 and June 2015. As you can see, there is a very strong correlation between these instruments. However, sometimes the currency pair will have a delayed reaction. For example, the yield spread started to fall in early 2013, and while it led to consolidation in EURUSD, the currency pair did not start to really trend lower until June 2014. Nonetheless, it is clear from the chart that the relationship is strong.

Figure 22.2 EURUSD and Bond Spread

Figure 22.3 shows the relationship between GBPUSD and the 10-year UK Gilt and US Treasury yield spread. In this example, there was no delay in the reaction of GBPUSD to the movement in yields. The yield spread started to fall quickly between June 2014 and June 2015, and it coincided with the decline in GBPUSD.

Figure 22.3 GBPUSD and Bond Spread

Figure 22.4 takes a look at a nondollar pair, AUDNZD, and once again, we see a very strong correlation. This chart compares the AUDNZD currency pair with the 10-year Australian and New Zealand yield spread. Sometimes, the interest rate yield will lead the direction of AUDNZD, and other times, AUDNZD will be a leading indicator for the spread.

Figure 22.4 AUDNZD and Bond Spread

Interest Rate Differentials: Leading Indicator, Coincident Indicator, or Lagging Indicator?

We know that yield spreads and currencies have a strong correlation, but do currency pair prices predict interest rate movements, or do interest rate movements drive currency pair prices? Leading indicators are economic indicators that predict future events; coincident indicators are economic indicators that vary with economic events; lagging indicators are economic indicators that follow an economic event. For instance, if interest rate differentials predict future currency pair prices, interest rate differentials are said to be leading indicators of currency pair prices. Whether interest rate differentials are a leading, coincident, or lagging indicator of currency pair prices depends on how much traders care about future rates versus current rates. Assuming efficient markets, if currency traders only care about current interest rates and not about future rates, one would expect a coincident relationship. If currency traders consider both current and future rates, one would expect interest rate differentials to be a leading indicator of currency prices. The rule of thumb is that when there is a big move in the yield spread, it will coincide with a big move in the currency pair; and if that hasn't happen, then it signals an imminent move in the pair. No correlation is perfect. There will be times when interest rate differentials matter more than others and that tends to be when central banks are at the cusp of or engaging in major monetary policy changes.