I’ve been meaning to write this piece for a while now but breaking down such complex information requires attention to detail. I hope you enjoy.
What Is A Bond?
Simply put, a bond is an IOU between the lender and borrower. Now these “IOU” agreements can range over different maturities from a few months or less than a year (T-bills) to 10 or 30-year maturities. Your next question may be, who issues these instruments? Governments, corporations and municipalities (local/town governments). Now, these entities will issue bonds to fund projects and expansions.
As you know if we were to walk to a high street bank and request a loan for £3,000 we will end up paying more than the original principal borrowed; we would pay the bank a premium for providing the capital; the same applies to institutions. This is known as the yield an investor receives annually for purchasing a bond, an incentive to lend relative to the risk/credit worthiness of the borrower.
Attractive Yields, Bond Prices and Rates
With bonds the higher the price, the lower the yield and the lower the price the higher the yield.
Bonds are one of the greatest instruments which serve as a proxy for risk tolerance, interest rate expectations and the strength of an economy. During times of perceived risk, you’ll see investors run to U.S10y bonds and the dollar respectively, this demand for bonds drives the prices higher and yield lower. Usually, it’s such the case that when yields are lower the domestic currency will follow suit and depreciate, however, when dealing with the dollar, due to it being a world reserve currency many factors affect its correlation.
One thing you have to keep in mind is that it’s never just one variable that will drive a particular asset, currency or instrument’s performance/correlation, things such as interest rate differential, yield differential, monetary policy, commodity influence and trade balance all will impact the movement of that instrument.
But for today, let’s keep it top level and assume that lower yields tend to drive the domestic currency lower as well. You’re probably asking why is that the case?
Here’s an explanation:
Economies that offer higher yields on their bonds tend to attract more investment. This would make their local currency more attractive than other countries offering bonds yielding a lower rate; as a result, an appreciation in the currency.
For instance, let’s consider something ongoing in the macro landscape. Japan and the U.S both offer 10year debt instruments (US10y and 10y JGB). Interest rates in Japan sit negative at 0.1%, over in the U.S interest rates sit at 1.75%.
As interest rates rise, prices fall and yields rise; as rates fall prices rise and yields fall which is what we’re seeing in Japan.
Currently, US10y is yielding roughly 3.30% per annum and 10y JGB (Japanese Government Bonds) yielding 0.23%. As an investor, with capital ready to deploy, which instrument presents the better yield? Clearly the U.S10y yielding you 3.30% vs 0.23% from Japan.
Now here’s where it gets fun, due to the yield differential of 3.07% (3.30 - 0.23) the dollar is now more attractive than the Japanese yen and because of this, the currency rates will show that. You can see the heavy devaluation of the Yen and the appreciation of the dollar across this time span from 2022 onwards.
This is known as the spread between two countries’ bonds. As the bond spread between two economies widens, the currency of the country with the higher bond yield will appreciate against the currency of the country with a lower bond yield.
Another great example if you’re a trader and can recall the 23rd of June 2016, Brexit day. When the UK exited Brexit, credit spreads between the UK and U.S widened roughly 90 bps; presenting a short trade for GBP/USD as you would have been able to realise investors will flow out of UK Gilts and into U.S10y due to greater safety and better yield.
If you’re like me you can then begin to look into more complex trades such as a carry trade and try to understand how that would work out. But for the purpose of this piece, I won’t dive into this.
I hope you enjoyed the 101 breakdown— bonds are something that still confuses me but a basic understanding can help you navigate FX markets with greater confidence.
Go on and share this with whoever you chose! It’s always good hearing and seeing your feedback
Until next time