The Currency Market And The Bond Market

Interest rate changes are always keenly watched by the market analysts

. Interest rate change by any Central Bank can have implications for many currency pairs. Especially in case of US, when FED decides to increase or decrease the interest rate, it has global implications and affects many currency pairs including all those having US Dollar (USD) on either side as a base currency or counter currency. FOMC ( Federal Open Market Committee) of the FED is responsible for deciding the interest rate changes in US. FOMC meetings are the second most market moving releases after the NFP (Nonfarm Payrolls). So always watch out for FOMC announcements.

Currency markets are also highly susceptible to interest rate changes. An interest rate differential in forex trading means the difference between the interest rate on the base currency (first currency in the pair) minus the counter currency (the second currency in the pair). Everyday at 5:00 PM EST, funds are either paid by trader to their brokers or received by traders from their brokers depending on whether the interest differential is negative or positive on the currency pairs they are trading. So knowing these interest rate differentials is highly important for a currency trader.

Today, we like in a global economy. Money has become a hot commodity that keeps on flowing from one market to another in search of better returns. Investors, hedge funds, big banks, corporations, pension funds, institutional investors and wealthy people are always seeking high yielding assets. They are ever ready to shift their assets where the yield is high! Millions of dollars can now be shifted by just a few mouse clicks.

Now, let's take an example to make things more clear. Take the example of Switzerland and United States. Suppose, Swiss 10 year government bonds are paying a yield of 5.5%. On the other hand, the US 10 year government bond also known as a US Treasury Note is only paying 2.0% interest. The yield spread between the two government bonds will be 3.5% or 350 basis points. This yield spread is in favor of Switzerland. Swiss government wants more foreign investors to come to Switzerland and deposit their money in Swiss Banks. Now, Swiss government decides to further increase the interest rate by 0.5% or 50 basis points. The new bond yield spread will be now 4.0% or 400 basis points. More foreign investors will start flocking towards Switzerland. This will put an upward pressure on Swiss Franc (CHF) and in the near future CHF will appreciate relative to USD.

Knowing the interest rate differential between the two currencies in a currency pair is very important for any currency trader. But how do you calculate this interest rate differential. The best way is to go on Bloomberg and note the yields on the different 10 year government bonds. Suppose you are trading GBPUSD, one of the heavily traded currency pairs. How do you calculate it's yield spread? Take the yield on 10 year US Teasury Note and subtract it from the 10 year British gilt. Keep track of this interest rate differential overtime. This can be a leading indicator of what is going to happen to the GBPUSD pair. Incase, you are trading the EURUSD pair, subtract the yield on 10 year US Treasury Note from 10 year German government bond.

Make a graph of this interest rate differential overtime! If this graph is steadily moving up, it means that the currency pair is going to appreciate and if it is steadily going down, it means that the currency pair will depreciate. Understanding this correlation between the currency pair prices and the interest rate differential can be highly profitable for your currency trading career!

by: Ahmad Hassam

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