As a fellow retail trader I feel it is an obligation to share information that is helpful.
That’s why I love being able to write and talk about the markets.
Even when I got my role as a senior market analyst at a brokerage firm, my goal has always been to provide information that can help traders progress. Now admittedly the task isn’t an easy one. The truth is, good trading or at least consistent trading can be hard to achieve.
But today I am going to show you a little hack that helped me gain consistency within my trading. It might help you too!
You may have heard about trading with bond yields before and are probably familiar with US 10 bond yields. Or you have heard about bonds before at least, especially if you listen to financial media.
But what if I told you that, these bond yields can help identify strong or weak currencies?
And if you don’t know me by now, well, identifying strong or weak currencies is my bag. It’s what I do. It’s what I have to do in order to make sense of these hectic markets.
Let’s ease ourselves into it.
What is a bond yield?
A bond yield is basically the return you earn for holding a bond. And what is a bond you may ask? Well that is a type of loan, typically backed by a company or in the world of FX the government. A bond tends to have different maturity lengths, the most common being 2, 5, 10 and 30 years. The yield is what you get back for holding either one of these bonds.
Why care? Well…
A government will need to raise capital, this can be for infrastructure, education, public services, national security or even economic stimulus.
Think of a small business owner needing capital to expand their business, so they will likely go to family, friends or even a financial institution like a bank for a loan.
The difference being the bonds are typically backed by a government (makes them safer than traditional loans), which means the purchaser will get their loan back plus interest (or the yield).
Here's how it works:
The government needs money so they issue bonds.
The investor buys a bond, essentially the government loans money from the investor.
The government then pays the investor interest, this can happen once or twice a year.
When the bond reaches its maturity date, the government pays the investor back the full amount they originally lent.
Put it this way, say you are the investor and your mate Dave is the government. Dave comes to you and asks for £1000 to help with bills, or has a small business and wants to loan some money. Your mate Dave (the government) offers to pay back your £1000 plus an extra £50 for goodwill in a year's time. Giving you a return of investment of 5%.
That in a nutshell is how bonds work.
But let’s be real, bonds are a lot more complicated than that.
Know you may ask…
How do they impact currency rates?
When a government issues a bond it will usually offer a certain interest rate, which is known as the bond yield. If the interest rates are high compared to other countries it can attract investors. Why? Well simply because it has a higher interest rate.
If you had a guarantee of a return on your investment and were offered 5% or 10%, you’d take the 10% all day every day!
In FX markets it can work like this:
UK interest rate is 4.50%, whilst the Euro Area interest rate is 2.65%. What we could see in this environment is money flowing away from Europe and into the UK. To do this investors would have to SELL EURO and BUY GBP. Which could see EURGBP fall.
This sounds great in real terms but the problem with using interest rates like this, is central banks don’t change interest rates that regularly. In fact it can be months before they change interest rates.
This is why we can look at the bond yields as this can show us future expectations of where rates could be.
We do this by looking at the 2 year bond yields as these tend to react to current interest rates expectations.
Take a look at this:
US02Y vs US Interest Rate
In the image we can see the US 2-year Bond Yields (black line) vs US Interest Rates (purple line). What we can see is that US-2 year Bond Yields tend to move first before the interest rate.
Why?
Well, bond traders are trying to predict where interest rates will be using all the macro indicators they can get their hands on.
Remember if bond yields rise, then we often see investors flow into that yield, which appreciates the currency related.
In this case the USD strengthened.
Have a look here:
US02Y vs US Interest Rate vs USD/EUR
Pretty cool right!!
Let’s go further.
We can compare the different bond yields from countries together to look for the differential between the two. You can follow along with me to do this if you wish, if you use TradingView software (which can be free).
Type into the terminal the following:
EU02Y - US02Y (hit enter). This should bring up the differential between the two countries' bond yield.
Next, hit the compare tool (the plus button top left) and type EURUSD. Add this to a new price scale.
EURUSD vs EU02Y - US02Y
This is what you should see, the government bond differentials vs EURUSD. What you will notice is that the yields can often lead the EURUSD price.
When this chart moves higher, around a week to two weeks later the EURUSD price can go with it.
THIS IS HUGE!
Imagine having a tool like this you can check on from time to time to give you a gauge of where bond traders are doing business, this then could have a knock on effect on currency prices.
Go have a practice of this yourself, you can do this across multiple bond yields, and let us know how you get on!
