Forex Yields – Global markets are just one big interconnected network. We often see that commodity and futures prices influence currency movements, and vice versa. The same applies to the relationship between currencies and bond spreads (the difference between countries’ interest rates): the price of currencies can influence the monetary policy decisions of central banks around the world. , but monetary policy decisions and interest rates can also dictate the movement. of currency prices.
A stronger currency helps curb inflation, while a weaker currency increases inflation. Central banks benefit from this relationship as an indirect means to effectively manage their countries’ monetary policies. By understanding and monitoring these relationships and patterns, investors have a window into the currency market and therefore a way to predict and profit from currency movements.
To see how interest rates have played a role in determining currency, we can look to the recent past. After the tech bubble burst in 2000, traders shifted from seeking the highest possible returns to focusing on capital preservation. But with the United States offering interest rates below 2% (and even lower), many hedge funds and those with access to international markets went abroad in search of higher returns.
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Australia, which has the same risk factor as the United States, has offered interest rates above 5%. Thus, it attracted large inflows of investment funds to the country and, consequently, assets denominated in Australian dollars.
These large differences in interest rates gave rise to the carry trade, an interest rate arbitrage strategy that takes advantage of interest rate differences between two major economies while seeking to capitalize on the general trend or direction of a currency pair. This trade involves buying one currency and financing it with another. The two currencies most used to finance carry trades are the Japanese yen and the Swiss franc due to the exceptionally low interest rates in their countries.
The popularity of carry trading is one of the main reasons for the strength seen in pairs such as the Australian dollar and Japanese yen (AUD/JPY), the Australian dollar and the US dollar (AUD/USD) and the New Zealand dollar. . US dollar (NZD/USD), US dollar and Canadian dollar (USD/CAD).
However, individual investors find it difficult to send money back and forth between bank accounts around the world. The retail spread over exchange rates can offset any additional returns investors seek. On the other hand, investment banks, hedge funds, institutional investors, and senior commodity trading advisors (CTAs) typically have access to these global markets and the leverage to control low spreads.
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As a result, they move money around in search of the highest returns with the lowest sovereign risk (or default risk). When it comes to the bottom line, exchange rates move based on changes in money flows.
Individual investors can benefit from these changes in flows by monitoring yield spreads and anticipating changes in interest rates that may be implied by those yield spreads. The chart below is just one example of the strong relationship between interest rate differentials and the price of a currency.
Notice how the graph snapshots are almost perfect mirror images. The chart shows us that the five-year yield spread between the Australian dollar and the US dollar (represented by the blue line) was falling between 1989 and 1998. This coincided with a broad sell-off in the Australian dollar against the US dollar.
When the yield spread began to widen again in the summer of 2000, the Australian dollar responded with a similar rise a few months later. The advantage of the Australian dollar’s 2.5% differential over the US dollar over the next three years is equivalent to a 37% appreciation in the AUD/USD pair.
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Those traders who were able to participate in this transaction not only enjoyed significant capital appreciation, but also received the annual interest rate differential. Therefore, based on the relationship shown above, if the interest rate differential between Australia and the US continues to narrow (as expected) from the last date shown on the chart, the AUD/USD pair will eventually will also decrease.
This correlation between interest rate differentials and exchange rates is not limited to the AUD/USD pair; The same type of pattern can be seen in the USD/CAD, NZD/USD and GBP/USD currency pairs. Take a look at the following example of the interest rate spread of NZD and US five-year bonds versus NZD/USD.
The chart provides a better example of bond spreads as a leading indicator. The spread bottomed in the spring of 1999, while the NZD/USD pair did not bottom until the fall of 2000. Similarly, the yield spread began to increase in the summer of 2000, but the NZD/USD pair began to increase in 2000. Early fall 2001. The yield differential in the summer of 2002 may be significant in the future outside of normal.
History shows that the movement in the interest rate differential between New Zealand and the United States is eventually reflected in the currency pair. If the yield spread between New Zealand and the United States continues to decline, the NZD/USD yield spread is expected to also reach its highest levels.
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Five- and 10-year bond yield spreads can be used to gauge currencies. The general rule is that when the yield band widens in favor of a particular currency, that currency will rise against other currencies. But it must be remembered that exchange rate movements are affected not only by real changes in interest rates, but also by a change in economic assessment or by an increase or reduction in interest rates by central banks. The following table illustrates this point.
From what we can see from the chart, changes in the Federal Reserve’s economic assessment tend to cause sharp movements in the US dollar. The chart indicates that in 1998, when the Federal Reserve moved from a hawkish outlook (meaning the Fed intended to raise interest rates) to a neutral outlook, the dollar fell even before the Fed changed interest rates (note that on July 5, 1998, the blue line appears to fall before the red line).
We saw the same kind of dollar move when the Fed moved from a neutral to a hawkish stance in late 1999, and again when it adopted a more accommodative monetary policy in 2001. In fact, as soon as the Fed considered lowering rates interest rates, the dollar reacted. with a strong liquidation. If this relationship continues to hold in the future, investors can expect a little more room for the dollar to rise.
Despite the large number of scenarios in which this strategy works for predicting currency movements, it is certainly not the holy grail for making money in the forex markets. There are several scenarios in which this strategy can fail:
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As shown in the examples above, these relationships reinforce a long-term strategy. Currencies may not bottom until a year after interest rate differentials bottom. If a trader cannot commit to a time horizon of at least six to 12 months, the success of this strategy can decrease significantly. the reason? Currency valuations reflect economic fundamentals over time. There are often temporary imbalances between a currency pair, which can blur the true fundamentals between those countries.
Traders who use a lot of leverage may also not be suitable for the breadth of this strategy. For example, if a trader were to use 10x leverage with a 2% spread, they would turn 2% into 20%, and many firms offer up to 100x leverage, which tempts traders to take on greater risks and try to reach 2%. At 200%. However, leverage carries risks, and applying too much leverage can cause an investor to be prematurely kicked out of a long-term trade because he cannot tolerate short-term market fluctuations.
The key to the success of yield-seeking trading in the years after the tech bubble burst was the lack of attractive returns in the stock market. There was a period in early 2004 when the Japanese yen was soaring despite the zero interest policy. The reason was that the stock market was rising and the promise of higher returns attracted many underweight funds. Most major players have stopped doing business with Japan in the past 10 years because the country faced a long period of recession and offered zero interest rates. However, when the economy showed signs of recovery and the stock market began to rise again, money flowed back into Japan despite the country’s continued zero-interest policy.
This shows how the role of stocks in capital flow can reduce the success of bond yields in predicting currency movements.
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Risk aversion is a major driver of Forex markets. Return-based forex trading tends to be more successful in a risk-seeking environment and less successful in a risk-averse environment. That is, in risk-seeking environments, investors tend to adjust their portfolios and sell low-risk/high-value assets and buy high-risk/low-value assets.
The riskiest currencies – those with large current account deficits – are forced to resort to this option.
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