Forex and Yield Spreads

It’s
well known that currencies are closely linked to interest rates movements. The
reason of this relationship is pretty simple: higher interest rates tend to
attract foreign investment, increasing the demand and value of the currency. On
the other hand, lower interest rates tend to be less attractive for foreign
investment and decrease the currency's value.

Currencies
are traded in pairs, for example EUR/USD, AUD/CAD, EUR/JPY and so on. So, in
order to visually see the relationship between interest rates and currencies
you need to take the difference between the respective country’s bond yields
and the corresponding FX pair.

Let’s
see an example with EUR/USD. Since you have the EUR as the base currency, you
need to take the yield on the German bond (which is used as benchmark for the
Euro Area) and since you have the USD as the quote currency, you take the US
bond yield. The difference between the yield on the German bond and the US one
gives you the yield spread. See the chart below.

German and US bonds yield spread

Now
you just need to compare it with the EUR/USD price chart to see the relationship
and you will notice that the yield differential leads the price of EUR/USD. See
the chart below.

Yield Spread (blue), with EURUSD price chart (orange)

The
divergence between the yield spread and the EUR/USD price chart often led to
big swings as the exchange rate caught up with the yield spread at some point.
There can be many reasons in the short-term affecting the currency pair but in
the long term it follows the yield spread. See the chart below with the
divergences highlighted with boxes.

Divergences
between yield spread and EUR/USD price

Divergences between yield spread and EURUSD price

Don’t
trade just based on the charts and correlations but look for reasons and keep
yourself informed on the latest developments in the world. Yields will move
based on macro fundamentals, so you should be aware of that and when you see a
divergence that is not supported by fundamentals, be prepared to strike as soon
as the short term aligns with the long term.

This
article was written by Giuseppe Dellamotta.