Using bond spreads in your forex trading strategy

Whether you are dealing in the currency market, commodity market or the equity market they are all interconnected. The various markets also impact each other; it is not unusual to see a movement in the commodities or futures market influencing the trading session in the currencies market. An identical relationship also exists between currencies and bond spreads. A bond spread is the difference in the interest rate of various countries. Macroeconomic principles state that there is a direct relationship between inflation and currency strength. A weaker currency will increase inflation while a stronger currency will help to stop and even reduce inflation. So, the price of a currency makes a very big difference to the monetary policies of the countries around the world. These monetary policies and decisions coupled with interest rates in turn control the price of currencies. 
 Understand the impact of these occurrences on the currency market will give a trader insight into the movement of the market and will help in predicting the movement of currencies. 

 To understand the impact of interest rate on the currency market you need to look back at the tech bubble burst of 2000. Traders changed their market goals during this period and were then looking for capital preservation over high returns. The US interest rates at the time stood at 2% and there was a possibility that the Feds would cut it further. However the Australian interest rate was 5%. This presented a lucrative opportunity to hedge fund managers and other establishments that could trade overseas. The risk factor in the Australian and US markets were the same which meant that a profit of 3% could be made in the Australian market. This significant difference in the interest rate brought forth the concept of carry trade. 

 Carry trade is nothing but an interest rate arbitrage. This statutory uses the difference between the interest rates of two economies to make a profit while it aims to reap profits from the overall trend of the currency pair. The strategy is quite simple one would buy one currency and fund it with another. Usually currencies used for this purpose belong to economies that offer very low interests rates for instance Swiss francs and Japanese yen. You would couple these currencies with the currencies of high interest paying economies. A very popular currency pair in this category is the AUD/JPY (the Australian dollar and the Japanese yen) AUD/ USD ( the Australian dollar and the US dollar and USD/CAD (the Australian dollar and the Canadian dollar). 

 However it is simply not feasible for individual investors to use this strategy and at best it is reserved for hedge funds, banking and financial institutions and commodity trading advisors who can access the global markets and command a low spread. They also have the ability to move their money in search of the highest yield and lowest risk. 

 If you wondering how the small time individual investor can benefit from this information; here is the story; the shift in the flow of funds can be easily determined with the help of yield spreads and expectations for interest rate changes that may be a part of the yield spreads. This information can certainly be used by the individual trader for his/her benefit. If we were to compare the interest rate differential with the five year yield spread of a currency pair for example the AUD/USD and if the blips on the chart for both the figures are almost identical and if the if the yield spread shows a decline this can result in a sell off of the Australian Dollar against the US dollar. On the other hand if the yield spread increases the price of the AUD will also increase in response giving the AUD a spread advantage over the USD. This can equate to huge profits for traders who can get into this trade. They will not only gain from capital appreciation but also the annualized interest rate differential. If the interest rate differential continues to narrow the AUD will also decrease in response. 

 To put it simply, the thumb rule is that when the yield spread increases in favor of a currency there will be an appreciation in the value of that currency as compared to the other currency in the pair. And this rule can be used to predict market movement thus benefiting the trader.