part0033

In this chapter, I want to examine the relationship between bonds and currencies which in many ways can be described as the meeting of the two money markets. Where the cost of borrowing is set by the bond market, and the cost of doing business is executed in the currency markets.

As we have already seen, bonds tell us about the cost of borrowing money. We watch the bond yield as it can reveal, not only risk and money flow, but it can also signal the future direction of interest rates. And it is interest rates which are usually the single most important determinant of a currency’s value.

I say usually, because in the last few years the cataclysmic events which have rocked the financial world, interest rates have become significantly less important as most central banks have been forced to lower interest rates to historically low levels, where they have remained ever since.

This is one of the game changing principles which I referred to in my foreword to this book. Ten years ago, as a currency trader, interest rates would have been the most significant aspect of strength or weakness in a currency pair. Trends would have been established on interest rate differentials alone. This has all changed, and is a feature I discuss in the section on fundamental news along with its effect on the monthly economic releases.

Over the last few years and, with little prospect of interest rate changes in the short term, the forex markets have shifted their focus of attention to other market indicators, such as unemployment and housing data for a longer term view of economic activity and growth.

Lately, with rising commodity prices and the prospect of inflation and growth now on the horizon, as we start to come to the end of this long recessionary period, markets are once again starting to focus on interest rates.

Furthermore, with the slowing of the US quantitative easing programme, the bond markets will return to their natural place as the leading indicator of future interest rates which are so important to us as currency traders.

Furthermore, it is important to understand the link between interest rates and the value of a currency, is not merely the simplistic one of where they are at present. Of far greater importance is their overall direction and whether they are likely to go up or down in the future. In other words, we need to try to establish answers to the following questions:

We can tell a great deal about the future direction of interest rates from the bond markets and the bond yields we discussed earlier in the book. And the bond that is considered to be the most representative and predictive of longer term interest rates is the 10 year T bill. It is this bill which is the benchmark for our analysis. When looking at the future for interest rates in the US and the US dollar, it is the yield on the 10 year Treasury bill which should always be considered first.

The yield on the 10 year Treasury bill is the barometer, the standard against which interest rates are measured, simply because it is a time horizon most investors can comprehend. After all, trying to forecast interest rates thirty years ahead is almost impossible, and one or two years is too short a timescale to consider for longer term investments. Therefore, the ten year yield is the one to look at first.

However, let’s not forget the short term yields as these will not only confirm short term interest rates, but also give an insight into the mood of the market as the money flows into and out of bonds as a result of investor sentiment. In other words, as sentiment moves from high risk to lower risk and back again.

To recap. Longer term falling bond yields generally point to a weak economic picture and therefore lower interest rates. Longer term higher bond yields generally point to a stronger economic outlook, and therefore higher interest rates, as the prospect of inflation becomes a reality.

Whilst the interest rate of a particular currency is important on its own, the key is its relationship to other currencies. It is this relationship which ultimately dictates the flow of money and causes exchange rates to rise and fall. However, this feature has been singularly lacking in the last few years, but one which will return in due course, as the present financial maelstrom passes and markets begin to return to some degree of normality.

Assuming this does eventually happen, one of the most powerful signals will be when the interest rates of two currencies begin to diverge. In other words, the gap between the interest rates on two currencies becomes wider, with one moving higher and the other moving lower.

As I have mentioned already, in the last few years interest rates have slipped in terms of market importance but they are on the way back, as the global economy begins to emerge from this long recessionary period. In addition the hugely damaging currency wars now appear to be virtually over, and we are therefore likely to see interest rates rising, fuelled by inflation and economic growth which in turn will lead to increasing differential yields between currencies resulting in increased money flow.

To consider this concept further I would like to explain the carry trade in detail at this stage, not as a trading strategy in its own right (which it is), but as one used by banks the world over, who borrow money at low interest rates, in order to fund higher yielding loans. This creates huge flows of money as a direct result of the differential yield between two currencies. This too is coupled to the outlook for interest rates in the future.

You may, of course, already be familiar with the term 'carry trade', and indeed I mentioned it in one of the earlier chapters, but you may have the mistaken impression this is a trading strategy only used by speculative retail traders in currency.

This is wrong, but is often the impression given. Therefore, let me correct this now. First, the carry trade is used in both the bond and currency markets. Second, it is used by every bank in the world to generate revenue and profit. And here’s how and why.

The country with the lowest interest rates in the last twenty years has been Japan, which suffered the same collapse of its financial markets following the bursting of a credit bubble in the early 1990's.

This has many parallels to the financial crisis triggered by the US secondary mortgage market in late 2007 and onwards. Later in this book I will explain the Japanese yen in detail, but as a result of the financial collapse 20 years ago, the Japanese economy has struggled to recover.

As a result, interest rates in Japan have remained between zero and 0.5 percent ever since. This has created the perfect currency for one side of the carry trade. On the other side would be a currency with a high interest rate such as Australia, New Zealand or Canada. In the last few years we have seen interest rate differentials of five percent and higher, and for a carry trade there are always two components.

The first is the yield aspect with the interest rate differential giving the return. The second is the fluctuation in the underlying currency exchange rate which give a profit or potentially wipe out any gains from the interest rate yield. Now, stepping back several years when US interest rates were at 5% then typically this is what would happen.

An investor would borrow Japanese yen from a bank at an interest rate of say, 0.5%. They would then buy a US 10 year treasury bond in US dollars paying five percent interest. The investor stood to make 4.5 percent from the interest rate differential, but always with the underlying risk the currency exchange rate could go against the investment.

For example, if the US dollar gained by 5 percent against the Japanese yen, the investor would make 9.5 percent over the life of the bond. This is the combination of the interest yield and the underlying currency gain. However, if the dollar lost 5 percent against the yen, the investor would make a loss of 0.5 percent.

In the last few years, as the US dollar has continued to weaken interest rates in the US have fallen to historically low levels where they have remained for some time.

As a result the US dollar has now become the base currency for the carry trade, with outflows of US dollars into higher yielding bonds overseas, as investors look for carry trade yield differentials with currencies such as the Chinese yuan.

The reason here is this is one currency that is directly manipulated by the Chinese, and therefore considered to be undervalued were it ever to become a free floating currency.

This is how an interest rate differential directly affects the flow of money from one currency to another with the bond market at the centre. The reason is simple. As a retail forex trader we could take a carry trade position on a particular pair, say the Aussie dollar and the Japanese yen. To open our position we would simply place a buy order effectively buying the Aussie dollar and selling the Japanese yen.

Our carry trade is now open and we will be paid the interest rate differential every 24 hours by our broker, as well as benefit or lose from the currency movement when we close the position.

For the banks it’s different, as they are generally trading in real cash so when they want to take advantage of the carry trade they have to look for investment instruments where they can place physically large amounts of cash. This is where the bond market comes into play. As a result they move money back and forth searching for the highest yields with the lowest risk.

It is these shifts in money flow, reflected in the bond yields which create the constant dynamic between one currency and another and which is why interest rates are so important to watch, analyse and understand.

There are two further key points to be aware of in the relationship between bonds and currencies and the carry trade which are as follows.

First, the carry trade is generally considered to be a longer term strategy for the banks, hedge funds, and institutional investors. And, as such, once the money flow begins, from one base currency to another, this is likely to continue for some time to come, generally creating a strong trend between the two currencies.

Second, the opposite is also true, and once this flow of money begins to unwind, it can do so very very quickly with dramatic results. Whilst all of this is very interesting, how do we, as retail forex traders take advantage of all this knowledge of money flow and interest rate differentials?

Whilst there is no holy grail in forex trading, one relationship we can study is that between interest rate differentials and currency exchange rates. The reason is because these tend to follow one another, driven by the desire of investors to benefit from the differentials in the bond yields. This creates spreads between the associated bonds of each country. And here is an example.

In November 2010 the Australian 10 year Treasury Note was trading at a yield of 5.37% whilst the equivalent US 10 year Treasury Note was trading at 2.88% giving a spread of 249 basis points – approximately 125 basis points wider than the historical norm.

At the time, the longer term prospects for both the US and Australian economies improved from November 2010 through to March 2011. Although the Federal Reserve held the Fed Funds Rate at 0.25%, markets had increasingly formed the view the US would not face any medium term threat from deflation, and by the end of the period markets could see an end to the then current QE program. The economic outlook was improving, helped by a weak currency, improved trade balance and ultra low interest rates.

By contrast, whilst the Australian economy was continuing to grow, other factors were now starting to suggest a possible slow down, not least because of a strong Australian dollar, subdued retail spending, and a possible slow down in demand from China. Over the period the RBA held interest rates at 4.75%.

By the start of 2011, with the economic recovery starting to take shape, the spread between the two bond yields narrowed considerably. By the end of March 2011, the Australian 10 year note was trading at 5.45% while the US 10 year note was trading at a yield of 3.68%. The yield spread between the two had narrowed to only 72 basis points.

So how was this reflected on the AUD/USD chart. From November 1st 2010 to April 1st 2011, the pair rose from 0.9865 to just below the 1.1000 level, a gain of more than 1000 pips. Indeed, prior to this, the pair had been rising strongly, as the spread widened in the run up to this period. The pair then topped out at the 1.1000 level before reversing lower in the following months, taking the pair back below parity once again.

At this point I must make two things clear, before you run away with the idea you can make money simply by using the link between a currency pair and differential bond yields as the ultimate determinant of strength and weakness.

First, whilst differential bond yields do give us strong clues, there may be many other factors that play in any currency relationship of which this is just one. Second, the relationship between bond yields and currencies may lag as these take time to be reflected in the associated price action.

The currencies, interest rate and associated bond yield relationship is a complex one, and I don’t want to give the impression this relationship will always work. This is not the case. Interest rates and bond yields move for many reasons, not least of which is risk appetite. In the last twelve months, we have also seen money flow into the Australian dollar as it is now also seen as an alternative safe haven currency. This is not surprising given the extent to which the Australian economy has been spared the worst of the ravages of the financial crisis. The same is also true of the Canadian dollar.

However, it is another weapon in our armoury and more reason not to be frightened of the bond markets as it can reveal so much about all the capital markets. A great site to follow bond prices and global bond yields is at www.investing.com .

Here you will find all the information you need. The data is live and it’s free.

Remember the bond market is where the money flows, not only when markets are nervous, but also when investors are looking for better returns, and one of the ways they do this is by using the carry trade with real cash moving both in and out of bonds.

Now, let me give you another example of how we can use interest rate differentials and the bond market to give us the clues and signals we need as forex traders. As an example let’s take the AUD/USD pair once again.

Suppose US bond yields rise by 5 basis points which is something we often see during the trading day, but at the same time we see Australian bond yields fall by the same amount. Again this would be normal for a trading day.

However, if we put these two events together the differential between the US dollar and the Australian dollar has widened by 10 basis points. Imagine this happened the following day again, we would have a twenty basis point differential between the two currencies. To put this into context.

If the Australian central bank cut interest rates by a quarter of one percent which is twenty five basis points move, you can guarantee one thing. The forex market would react, and fast.

This is how we have to use bonds and their unique relationship to currencies. In peering beneath the surface, the bonds reveal what the market is thinking, and what investors and speculators are doing with their money. Moreover, we use bond prices and bond yields in particular, to give us vital clues to the interest rate differentials between currencies which are ultimately one of the prime drivers of money flow.

I recommend you visit www.investing.com because, in addition to giving you all the bond prices and bond yields, there are also live charts for many of the other indices, markets and instruments I mention in this book. Finding live bond yield data for countries other than the US and US Treasuries can be difficult – this site makes it very easy. Here you can find information for all the major countries and their associated currencies. The link to the exact page is here:

http://www.investing.com/rates-bonds/world-government-bonds

Finally, as I have mentioned before, in addition to interest rate differentials, risk is also another of the primary drivers of money flow as the markets are driven by people and their money.

This is just the same in the forex market, where risk aversion is a key driver. As a result, trading strategies, such as the carry trade which is based on yields, tend to be more successful when risk appetite is high and less successful when risk appetite is low.

However, when we have rising commodities and equities because investors are taking on more risk, this is an environment when the carry trade would also do well. In this scenario traders and investors are prepared to take on the riskier currencies, which in turn offer higher interest rates to compensate for this risk.

Conversely, when risk is low and equity markets are falling, the carry trade may unwind, as traders and investors move into safer havens.

This is how the markets continually interact with one another in this constant dance of risk and return, with money flow in one reflecting movement in another.

And where do we look for market sentiment and risk? In the other capital markets and in a variety of indices which we are going to examine shortly.

Finally, of course, it goes without saying interest rates are the principle instrument most central banks have available with which to control growth, jobs, and international trade. However, their effect is rather like trying to put out a bonfire with a water pistol.

Central banks do have one or two other strategies which they can deploy and these are explained in a later chapter when we look at the central banks in detail. However, interest rates are their primary tool as they are simple to implement and have a relatively quick effect, hence they are their weapon of choice when fighting inflation, especially when it is out of control.

In reality central banks only have interest rates with which to control an economy. This makes the analysis of bond yields even more important as we try to interpret their long term monetary policy. At the same time we also have to consider the intraday movement of yields as market sentiment shifts hour by hour and day by day.

Differential bond yields can and do cause huge shifts in money flow as central banks also indulge in the carry trade. This can result in great trends which retail forex traders can also exploit.