The global financial markets are all interconnected. Those who have been trading in any market, including the equity market, commodity market or currency market, must have noticed that these impact each other.
For instance, a change in the prices of futures and commodities influences movements in the currencies and vice versa. This holds true in the case of currencies and bond spreads (the difference in the interest rates of different countries). Moreover, according to macroeconomic principles, inflation and currency strength share a direct relationship. That means that a stronger currency can stop or reduce inflation, and a weaker currency can boost inflation.
So, the monetary policies of various countries across the globe are impacted by the price of currencies. This relationship enables central banks worldwide to effectively make decisions regarding the monetary policies of their respective countries. Such decisions regulate the price of currencies, and monetary policies are in accordance with interest rates.
Let us first understand the concept of bond spreads in relation to the forex market.
What is Bond Spreads?
The term bond spread, as mentioned earlier, refers to the difference between various countries’ interest rates. Traders use this bond spread to plan their trading strategies and thereby make profitable trades. This especially holds in the currency market. In the forex market, the bond spread can indicate the economic strength and thereby also the currency’s relative value.
Traders must be aware that the value of a currency rises with a rise in interest rates. This relationship works well during periods of prosperity, during which traders accept risks. On the other hand, the relationship between currencies and bond spreads fails because investors go for the safest assets, leading to plummeting yields.
What Does Interest Have to Do With Currencies?
The bearish trends in various markets in 2000 vividly demonstrated the role played by interest rates in determining currencies. Traders started focusing on capital preservation rather than maximizing their returns. While the interest rate offered in the US was 2%, Australia offered interest rates upwards of 5% with the same risk factor. Due to wide differences between the interest rates of different countries, carry trade emerged.
Carry trade is an interest rate arbitrage strategy that leverages the difference between the interest rates of two major economies and aims to benefit from the normal trend of the currency pair. The carry trade involves investing in one currency using another currency. The Japanese yen and the Swiss franc are the most common currencies in carrying trade due to their considerably low-interest rates. Due to the popularity of carrying trade, pairs such as AUD/JPY and AUD/USD became stronger.