Can someone please help me to understand how the bond market works in relation to currency movement?
In the US market for instance are analysts watching treasury yields as a leading indicator? If yields suddenly change what effect does it have on everything else? What causes the yield to change?
I came across this off the dailyfx site and the concept is a blind spot for me which Id like to shine a light on.
One such market that many fund managers keep an eye on is the bond market. The bond market is seen as the leader of stocks,currencies, and commodities whereas commodities are the last to turn. Should the bond market or another key market that is correlated to the underlying currency pair begin to turn against its prior trend, that move could cause other large traders to take note and exit the trade that can have a cascading affect.
The bond market is a big subject. This article might help.
As to how it relates to forex, yields are closely intertwined with exchange rates - especially short-term rates. Rising rates - or more correctly, the expectations of - tend to strengthen a currency. And vice versa for falling rates.
Thats actually quite a good website thanks for sharing. This page has some awesome nuggets of wisdom.
I am unlikely to be a good day trader if I cannot dedicate my days to watching the markets for long stretches and frequently buying and selling
Newbies such as myself need the discipline to do lots of watching and observing. I found as soon as I cut all the news, comments, analysts (especially the bloody analysts) etc. and just focused on myself and my belief in what was happening, I started making much better decisions.
After reading these excellent articles am I correct in saying that when the FED increases rates, the dollar will strengthen due to positive sentiment. Which in turn, drives the price of bonds down?
The reason the price of bonds gets driven down is if you paid $100 for a bond with a 3% yield then (all things being perfect) you can expect the $100 back at maturity including the yield of $3.
However if the USD strengthens by 10%, it means that the bond you purchased is now only worth $90. And consequently your yield amount is now only worth $2.7.
So my question becomes, how is it that the bond market is a leading indicator? If the price of a bond is directly correlated to the strength of the currency then the forex market is the ultimate leading indicator?
the bond market serves for the real industry as a big security market. banks and institutions use bonds to park money instead of parking it at the FED or in risky assets like srocks. if fed rises interest rates and the dollar gets worth more usually this triggers a switch from stocks to bonds resulting that the bond yield lessend aswell (from 3.5% to lets say 3% for example).
other countries and banks and institutions aswell purchase bonds of countries that are beeing seen as âsecureâ so lets say the dollar is supposed to rally (due to fed %-hike) against the ⏠then as a instituion it is in my interest to purchase US bonds more than EURO bonds. as in the dollar rise in worth i have a leverage effect of the %gains the bond is paying out.
but this is just a side effect.
interest rates and risks / risk aversion determine the price of a bond not the currency market.
bonds can influence the currency market under special circunstances. take a look at switzerland. swiss bonds have been seen as secure heaven in the crisis and the aftermatch of the crisis in 2008. that resultet many foreign institutions wanting to purchasecswiss bonds as security abd therefore had to buy swiss frank. zhe swiss frank rose in worth a lot in the years after the crisis and still did not come back down since the bonds are still beeing held by the foreign owners. once they start mass expiring it will effect the swiss frank aswell again when the investors start pulling the money out again.
i really wanted to answare on ur question but it would take me to tipe a lot of pages and i had not had the time. so when i find sone time ill write u a more detailed text, if i find the time anytime soon.
you asked a very complicated question which can be answared but you first need to know the basics of bond markets to answare a advanced question.
bit anyways heres a short introduction: the currency market usually does have minimal effect on bonds simply because most bond purchasers are institutions (banks, pension funds, big insurance companies) which come from the domestic market. US institutionals buy bonds from US government. Bonds serve to finance the future operations of a country. very little percentage of bond purchases are done from foreign investors. - carry trades are a factor in bond purchases as you can increase your yield by buyibg US bonds with a currency that is cheaper to borrow then USD. lets say for example you want to purcgase bonds in worth of 1 billion $ bit have 100million only. you can lend money from the FED directly and pay interest rates on 900 million. these interest rates you pay are less than what the bond pays you in interest rates so you leveraged your operation by the factor ten minus interest rates difference. if you want to trade it even more sharp you go to a central bank which gives you a cheaper interest rate („) and purchase the 900m bonds with yen. but this currency trade has no effect on the bond prize as you would purchase them anyways wether it was with $ or „. it aswell has little effect on the $/„ exchange rate since the „ you purchased 'leveraged- you back up with leveraged $.
First, the bond and exchange rate markets are separate and while they often are linked by common fundamental drivers, they can also be separately influenced by their own developments.
Second, when the Fed increases rates itâs primary influence is on the bond market since thatâs where itâs operating. Anything that happens in the dollar is a secondary effect.
Third, bond prices are NOT driven by changes in USD exchange rates. They are driven by changes in US yields, which are a bond market mechanism. Do changing USD exchange rates influence the demand for US bonds from overseas investors? Sure. But not the way you have described.
Side note: a 10% rise in the USD would increase the value of a bond to an overseas investor, not lower it.
Finally, I would not call either bonds or exchange rates leading indicators for the other - at least not consistently. They trade too much on a common set of fundamental factors.
SoâŠif a hedge fund has 1 billion they look purely at how much it can yield for them. Instead of high risk investments they go to the safety of the bond market where they will get a guaranteed yield per year. Once a fund has paid say $100 (keep this simple) for a bond and they are getting say 3% a year until maturity, what would change the value of that $100 bond?
What makes the price fluctuate? If someone paid $100 for a bond why would the next guy pay $110 for it at a later date knowing that he is paying a premium and on maturity he will loose $10?
What makes the yield change?
Fed fund futures are now pricing in a 70% chance of another rate hike in June and a 100% chance of another round tightening in the second half of the year. So not only is Yellen unfazed by the potential negative economic impact of higher yields but she felt confident enough in the economy to signal that the tightening program will continue in the New Year.
In the quote above, why would higher yields be cause for a negative economic impact ?
in simplified explanation yes. you dont walk around with 1 billion trying to gamble, you go on safe earnings. that is caled wealth accumulation. in your example you would have a profit before inflation of 30 million a year. in more complicated and advanced business you can boost (leverage) that profit to 210million a year.
Example:
1b in bonds which pay 3% anually = +30 million /anually
9b borrowed from bank at a interest rate of 1% = (-) 90 million/anually
bought new bonds in worth of 9b (with borrowed money) which pay anually 3% = +270million/anually
end result = 210 million
end result anually gain from 1 billion invested = 210 million = 21%
so very safe 21% every year unless central bank changes the basis interest rates towards higher (which happened yesterday).
this is a combination of interest rates basis points and inflation. lets say you have a inflation of 0,5% and a bond yield of 3% then the bond creates a surplus of $2,5. now when you own bonds (bonds are not limit less created= not everybody who wants a bond will get a bond) and you want to sell it (for whatever reason there might be= you need capital to purchase another asset, or investors want to retrieve money from your fund, or whatever) you can sell it to institutuons who need a bond (again, for whatever reason= they need to increase their basic security percentage because they have been giving out too many credits to companies or private people and in order to comply to BASEL III- banking rules [for more information read here= Basel III - Wikipedia]).
considered example above the person who must provide security according to rules governments set rather buys a bond than park cash money at a central bank. why? because parked money gives nothing. it doesnt even cover inflation. In some central banks you must even pay penalties to park money in them (security). while bonds are beeing seen as 100% failsafe securities which aswell help to finance a country.
so the institution that must increase its security rate has 2 choises. where the first (park money at central banks) will cost them money, while owning bonds will make them earn money.
the bond will always be worth $100 (your simplified example) while it yields $3 a year. so even if you have a inflation of $0,5 you still earn $2,5, so you have a âplay areaâ of $2,5. that means even if you pay for the bond lets say a premium of 1,5% (you pay for it $101,5) plus earned interest rate of %3 (plus $3) minus inflation of %0,5 you still have a surplus of $1 (1%) insrtead of having to pay and take a loss on parking money somewhere.
there are 2 explanations for what youve been quoting since you dont specify what yield is meant:
1st interest rate yields from central bank:
higher interest rate from Central bank means less loans given out to companies and private people and aswell results in more expensive loans. this results in a slowdown of economy since less is beeing invested in raw goods and real estate etc etc. but thats a complicated manner and the explanation you can find here:
it explains what conection interest rates and economic growth should have (i say should because the theory is beeing questioned since few years, even thou the global economy is still sticking to the Keynesian theory).
2nd yields for bonds:
countries finance themselves and their future by giving out bonds and paying interest on them. they pay streets, infrastructure, finance military, education and economic programs. if the interest rate they must pay on these bonds increase it means that financing these project and all day duties becomes more expensive. that means that government spending is beeing reduced to meet with the available income (from taxes citizen are paying) in order to not have a too negative household. reduced governments spending (again check Keynesian theory) directly results in less growth (less streets beeing build= street building companies earn less ⊠buy no new machines⊠fire employees⊠etc etc).
regarding your first post in this thread:
if you realy are interested in inter market analysis (thats what its called if you want cloues from one market to judge what another market should be doing in near future) you should start reading this book:
it is a masterpiece and a very advanced book which will teach you what you need to know about how to technically analyze different markets and the connection inbetween.
but be warned to not waist your time if you are/or planing to be a daytrader. this will not benefit your trading in any way as a daytrader. even for swing traders this is rather useless knowledge. it is very usefull for the long time framge investor who holds positions over years.
heres a quote which shows a lot of similarities (prior to 1987 crash) between back then and today. history repeats itself al over always.
THE LOW-INFLATION ENVIRONMENT AND THE BULL MARKET IN STOCKS
Iâll start the examination of the 1987 events by looking at the situation in the commod-
ity markets and the bond market. Two of the main supporting factors behind the bull
market in stocks that began in 1982 were falling commodity prices (lower inflation)
and falling interest rates (rising bond prices). Commodity prices (represented by the
Commodity Research Bureau Index) had been dropping since 1980. Long-term interest
rates topped out in 1981. Going into the 1980s, therefore, falling commodity prices
signaled that the inflationary spiral of the 1970s had ended. The subsequent drop
in commodity prices and interest rate yields provided a low inflation environment,
which fueled strong bull markets in bonds and stocks.
In later chapters many of these relationships will be examined in more depth.
For now, Iâll simply state the basic premise that generally the CRB Index moves in
the same direction as interest rate yields and in the opposite direction of bond prices.
Falling commodity prices are generally bullish for bonds. In turn, rising bond prices
are generally bullish for stocks.
Going into 1986 bond prices were rising and commodity prices were falling. In the spring of 1986 the commodity price level
began to level off and formed what later came to be seen as a âleft shoulderâ in a
major inverse âhead and shouldersâ bottom that was resolved by a bullish breakout in
the spring of 1987. Two specific events help explain that recovery in the CRB Index in 1986. One was the Chernobyl nuclear accident in Russia in April 1986 which
caused strong reflex rallies in many commodity markets. The other factor was that
crude oil prices, which had been in a freefall from $32.00 to $10.00, hit bottom the
same month and began to rally.
Figure 2.1 shows that the actual top in bond prices in the spring of 1986 coin-
-ided with the formation of the âleft shoulderâ in the CRB Index. (The bond market
is particularly sensitive to trends in the oil market.) The following year saw side-
ways movement in both the bond market and the CRB Index, which eventually led
to major trend reversals in both markets in 1987. What happened during the en-
suing 12 months is a dramatic example not only of the strong inverse relationship
between commodities and bonds but also of why itâs so important to take intermarket
comparisons into consideration.
Thanks so much for taking the time to explain that to me. I find it incredible that large institutions make so much in interest on borrowed money!
This helped me understand what the big deal is with rates:
if the interest rate they must pay on these bonds increase it means that financing these project and all day duties becomes more expensive. that means that government spending is beeing reduced to meet with the available income (from taxes citizen are paying) in order to not have a too negative household. reduced governments spending (again check Keynesian theory) directly results in less growth (less streets beeing build= street building companies earn less ⊠buy no new machines⊠fire employees⊠etc etc).
lets say for example you want to purcgase bonds in worth of 1 billion $ bit have 100million only. you can lend money from the FED directly and pay interest rates on 900 million. these interest rates you pay are less than what the bond pays you in interest rates so you leveraged your operation by the factor ten minus interest rates difference.
If that is the case why doesnt the group issuing the bond fund the operation direct from the fed and enjoy a reduced interest repayment? Fed can print as much as they want and all that money will go into the local economy.
interest rates and risks / risk aversion determine the price of a bond not the currency market.
In the months and years between interest rate changes bond prices are driven by sentiment? And that is why everyone is so concerned about what politicians are saying and data releases etc. So the daily fluctuations of bond and treasury yields will have almost zero impact on the currency?
thats a very good question, sounds logic doesnt it? but unfortunately it does not work this way. the central banks are not created to finance countries/government spending. theres a lot of debate happening the last few years to which extend the central banks are actualy financing countries (BoE is in fact financing UK after its brexit) and why or how that is wrong.
Central banks have been created to serve 2 points:
1st. control money supply (that does not include necesarrily to print money like copy paper like they do in todays times)
2nd. control extensive inflation or deflation
the role of a central bank is to balance the money supply in exat amount that it does not hurt the economy but aswell does not artificially boost it.
the question of why governments dont borrow money from central banks directly is the same like the question of communism (a planed economy) is better or worse than capitalism (a free plan economy which takes care of itself).
when a central bank prints new money it does not create ânew moneyâ it in fact creates absolutely nothing. it is only incresing the amount of money that exists, and that decreses the value of money so the equation ends with a 0. no gain no loss. a government/country on the other side functions by âworkâ of its citizen. that work is mirrored with the money these citizen are earning. lets take a look at money itself to answare that question; you cant eat it, you cant drink it, you cantwear it, you cant drive around in it, you cant push it in your veins and it for sure will not heal any illness you have if you manage to push it in your veins. its just an exchange for goods. a country/government needs goods and service to survive not money. so if governments would be able to actually print as much money as they like we would only see a hyper inflation but no economical effects. since the money printed by the central bank is in fact only worthless paper, whats worth on this paper is what people are willing to do for it.
the central bank is there for balance only. if a government can print as much money as they like then they dont need to control anything of their budget. they simply print new ones (we have seen that in Germany after the first world war when they started printing money, 1919 a piece of breat costed 1 reichsmark, and only few years later a piece of bread costet 2 billion reichsmark.
check here:
To pay for the large costs of the ongoing First World War, Germany suspended the gold standard (the convertibility of its currency to gold) when the war broke out. Unlike the French Third Republic, which imposed its first income tax to pay for the war, German Emperor Wilhelm II and the German parliament decided unanimously to fund the war entirely by borrowing,[1] a decision criticized by financial experts such as Hjalmar Schacht as a dangerous risk for currency devaluation.[2]
The government believed that it would be able to pay off the debt by winning the war, and it would be able to annex resource-rich industrial territory in the west and east. Also, it would be able to impose massive reparations on the defeated Allies.[3] The exchange rate of the mark against the US dollar thus steadily devalued from 4.2 to 7.9 marks per dollar.[4] (It was only after the war that the extreme hyperinflation occurred.)
The strategy backfired when Germany lost the war. The new Weimar Republic was now saddled with a massive war debt that it could not afford. That was made even worse by the fact that it was printing money without the economic resources to back it up.[3] The Treaty of Versailles further accelerated the decline in the value of the mark so 48 paper marks were required to buy a US dollar by late 1919.[5]
German currency was relatively stable at about 90 marks per dollar during the first half of 1921.[6] Because the Western Front was mostly in France and Belgium, Germany came out of the war with most of its industrial infrastructure intact. It was, in fact, in a better position to become the dominant economic force on the European continent.[7]
The London Ultimatum in May 1921, however, demanded World War I reparations in gold or foreign currency to be paid in annual installments of 2 billion gold marks, plus 26% of the value of Germanyâs exports.[8]
The first payment was made, when it came due in June 1921.[9] It marked the beginning of an increasingly rapid devaluation of the mark, which fell in value to approximately 330 marks per dollar.[5] The total reparations demanded were 132 billion gold marks, but Germany had to pay only 50 billion marks.[10]
Since reparations were required to be repaid in hard currency, not the rapidly depreciating paper mark, one strategy that Germany used was the mass printing of bank notes to buy foreign currency, which was then used to pay reparations. That greatly exacerbated the inflation of the paper mark.[11][12]
Hyperinflation
Weimar Republic hyperinflation from one to a trillion paper marks per gold mark; the logarithmic scale is used.
From August 1921, Germany began to buy foreign currency with marks at any price, but that only increased the speed of breakdown in the value of the mark.[13] As the mark sank in international markets, more and more marks were required to buy the foreign currency that was demanded by the Reparations Commission.[12]
In the first half of 1922, the mark stabilized at about 320 marks per dollar.[5] International reparations conferences were being held. One, in June 1922, was organized by US investment banker J. P. Morgan, Jr.[14] The meetings produced no workable solution and so inflation changed to hyperinflation, and the mark fell to 7,400 marks per US dollar by December 1922.[5] The cost-of-living index was 41 in June 1922 and 685 in December, a 15-fold increase.
By fall 1922, Germany found itself unable to make reparations payments since the price of gold was now well beyond what it could afford.[15] Also, the mark was by now practically worthless, making it impossible for Germany to buy foreign exchange or gold using paper marks. Instead, reparations were to be paid in goods such as coal. In January 1923, French and Belgian troops occupied the Ruhr, the industrial region of Germany in the Ruhr valley, to ensure reparations payments. Inflation was exacerbated when workers in the Ruhr went on a general strike and the German government printed more money to continue paying for their passive resistance.[16] By November 1923, 1 US dollar was worth 4,210,500,000,000 German marks.
this is exactly what happens when a country funds itself with a central bank.
that is a field someone else can answare you better than me. i am by no means a currency trader. i dont trade currencies at all, so the daily impact on currencies of changes in bond prices is nothing that i have tried to observe or beein interested in. from what i have observed thou im rather sure to say; no that has barely any impact on currency prices in the short run. in the long run it can have big impacts on currency prizes like i explained on the swiss frank in a post before.
Keep in mind that bond markets are continuously moving. They donât just move when the Fed changes interest rates. They are as much supply/demand dependent as all other markets. If there is demand for bonds from investors (usually an expression of risk aversion), then prices go up and yields go down. If there is a large amount of bond issuance (increase in supply) that can push prices down, driving yields up.
Thus the daily fluctuations of prices and yields in the bond market reflect investor expectations of the future combined with changes in bond supply (note: quantitative easing reduces the supply of bonds, thus driving up prices and down yields). Things like politician talk, fed speak, and data releases all play into that.
And yes, the short-term moves in yields donât have much impact on exchange rates. The primary reason is that exchange rate moves tend to express expectations for future yields.
A few things have happened since the above post - not least a certain lack of confidence.
From a TA perspective see how price was at the bottom of the gap when I posted - in the days subsequent did anything really change?
Many guys were of the opinion that confidence had returned, bonds were again bid, the BoE had stepped in to âcalm the marketâ by buying UK linkers (Gilts linked to inflation) all was rosy, disaster averted.
But was it?
Bottom line was that price merely filled the gap, the BoE signalled the bail-out was to be short-lived and must end today.
Will confidence return now that the UK Govt has made a huge U turn by today firing itâs Finance Minister and changing economic policy?
The Bond market will tell that tale in the days and weeks ahead.
That was 1 week back - confidence did in fact return in the days since - that is until late in the week with the PMâs resignation.
From a TA perspective itâs very clear that price created a dbl bottom and reflecting the renewed confidence went North, in fact gapped up Mon morning.
Then at the end of the week the news reversed - the PM resigned amid political turmoil.
And again TA was in tandem - only this time a dbl top reflecting a drop in confidence - even gapped down this morning.
Thatâs how the Bond Market works - a live indicator of investor sentiment.
I painted the down arrow yesterday when the news hit the fan - TA and FA in tandem.
