Forex and Bonds - Understanding Fundamental Analysis
Hello ladies and gentlemen, Forex traders!
Forex traders should have a general idea of other financial instruments. In addition, some knowledge can be turned into simple and effective trading strategies. This review will focus on the relationship of bonds and the Forex market. We will consider what they are, how bond yields affect the economies of countries and how to make a profit in the foreign exchange market by changing their rates. We show everything that is hidden.
What are bonds and why do they affect currencies?
The state issues bonds when it is necessary to raise additional funds to the budget. That is, the state takes money on loan for a specified period during which interest is paid to the securities holder. Funds may be required to cover the budget deficit, other debt and, in general, the financing of government projects.
Considering that bonds are always issued in very large volumes, this tool directly affects the development of the country's economy, influencing the size of the money supply, inflation and exchange rate. Therefore, the relationship with the foreign exchange market is a highly expected phenomenon.
For example, the red line on the graph represents the index of the dollar basket. The index can determine what is generally happening with the currency. The blue line is responsible for the yield of 10-year US Treasury bonds, in fact, the most popular bonds in the world.
As you can see, there is a strong direct correlation between the dollar basket and US bonds. That is, when bond yields rise, so does the dollar index; when yields fall, the dollar also sags.
This relationship can be explained by the fact that currencies in the Forex market are rising or falling, partly due to changes in interest rates at central banks. That is, it is the Central Bank that determines the trend.
But, since we cannot find out future rates in advance, we can only rely on expectations. In this regard, the bond market acts as a good leading indicator, since it is there that the earliest trends arise. If bond yields increase, so does the likelihood that the bank will decide to raise rates at the next meeting. The same thing, if the yield on bonds falls, it will soon be possible to lower rates.
But, we trade in currency pairs. How do we compare the returns of 2 different countries?
In this case, we will be helped by the chart of the yield spread of bonds.
First of all, we look at 10-year papers. At the same time, if you are interested in the EURUSD pair, you need to compare the yield of US and German bonds (the leading economy in the eurozone).
A currency pair has a concept of spread, but we can also calculate the spread for two bonds. This value can be used as an indicator of rising or falling pairs. So, the spread of two bonds is the difference in their yield. With the increase in the difference between German and American securities, EURUSD can be expected to increase, when the spread decreases, we expect the currency pair to fall.
Naturally, you need to look not at the momentary value, but at the dynamics of the spread change. That is, we look at the trend for several days or weeks, depending on the timeframe being traded. Let's say if you trade on an hourly chart, a few days will be enough. But if your main timeframe is daily, you need to analyze the spread for several weeks or months.
There are many different sites where bond yields are shown. For example, here you can take changes in bond yields of the USA, Japan, Great Britain and the Eurozone. There are also full charts of quotes.
The spread chart can be built on the TradingView platform. In the field for indicating the tool, you can specify your own formula, in this case, the difference between the two tools. That is, having two tickers, German and American bonds, we can build a spread chart according to the formula: current spread = DE10Y-US10Y. Enter the formula and press Enter to calculate the spread.
List of tickers by country:
- USA - US10Y
- Germany - DE10Y
- United Kingdom - GB10Y
- Japan - JP10Y
- India - IN10Y
- Spain - ES10Y
- France - FR10Y
- Ireland - IE10Y
- Italy - IT10Y
- Portugal - PT10Y
A list of all bonds can be obtained by the keyword BONDS in the search.
It is worth noting that despite the fact that 10-year securities are good for forecasting exchange rates, two-year plans are more suitable for forecasting interest rates. That is, a suitable bond term is chosen depending on the task.
Make a forecast
On the chart, the orange line represents the spread of 10-year German and American bonds. Blue line - EURUSD rate.
Most of the time we observe a strong direct correlation. That is, the exchange rate of the currency pair and the yield of securities go in the same direction. But at times, the so-called de-correlation occurs when a direct relationship is violated. It is at such moments that we can make a profit.
For example, if a currency pair grows, and the spread begins to fall - this is a signal that the exchange rate will also begin to decline soon. That is, the spread is a leading indicator, and if we see a violation of dependence, you need to open a position in the direction of the spread. In this case, when we fall, we enter the sale, on growth we enter the purchase.
In fact, it does not matter whose fault the correlation occurred. For example, the spread on bonds practically did not change when the pair fell sharply. In this case, the exchange rate is in the oversold zone, which means that you can rise at the first opportunity. To confirm, you can use any technical indicator, for example, Bollinger Bands. As soon as the price breaks the lower border from the bottom up - we enter the market.
So, remember, for trading we look at 10-year bonds of those countries whose currencies we trade. If it is EURUSD, look at the Eurozone and the USA. If it's GBPAUD - UK and Australia, and so on.
Choose a trend window depending on the trading timeframe. If you trade intraday, naturally, the dynamics of profitability over the past six months will say little about. But, if you are trading on a daily TF, you should just watch the trend over the past few weeks or months. For an hourly timeframe, 1-3 days will be enough.
Bonds are not a 100% guarantee of a successful forecast, but it is a very strong signal. Therefore, it is worth paying attention to other economic news, speeches of the heads of central banks, correlation with other instruments and so on. Also, to confirm the entry, especially within the day, use additional indicators - RSI, Bollinger Bands or any other that you are used to.