The bond spread represents the difference between two countries’ bond yields.
These differences give rise to carry trade, which we discussed in a previous lesson.
By monitoring bond spreads and expectations for interest rate changes, you will have an idea where currency pairs are headed.
Here’s what we mean:
As the bond spread between two economies widens, the currency of the country with the higher bond yield appreciates against the other currency of the country with the lower bond yield.
You can observe this phenomenon by looking at the graph of AUD/USD price action and the bond spread between Australian and U.S. 10-year government bonds from January 2000 to January 2012.
Notice that when the bond spread rose from 0.50% to 1.00% from 2002 to 2004, AUD/USD rose almost 50%, rising from .5000 to 0.7000.
The same happened in 2007, when the bond differential rose from 1.00% to 2.50%, AUD/USD rose from .7000 to just above .9000.
That’s 2,000 pips!
Once the recession of 2008 came along and all the major central banks started to cut their interest rates, AUD/USD plunged from the .9000 handle back down to 0.7000.
So what happened here?
One factor that is probably in play here is that traders are taking advantage of carry trades.
When bond spreads were increasing between the Aussie bonds and U.S. Treasuries, traders load up on their long AUD/USD positions.
To take advantage of carry trade!
However, once the Reserve Bank of Australia started cutting rates and bond spreads began to tighten, traders reacted by unwinding their long AUD/USD positions, as they were no longer as profitable.
Here’s one more example:
As the bond spread between the UK bond and US bond decreased, the GBP/USD weakened as well.