Government bonds and forex: what does a trader need to know?

An individual country's government bond market usually provides a good indication of its economic health, as does the relative valuation of a currency compared to other major currencies.

Additionally, the strength of bonds tends to influence the value of a currency, as large international investors tend to place their money where they can get the best bond rates. This flow of “big money” can significantly shift exchange rates in favor of higher-yielding currencies.

Government bonds, which are typically issued by a country's main treasury, play a central role in the value of a nation's currency because their issuance tends to increase the government's debt obligations. Additionally, average bond yields and bid-to-cover ratios directly impact the forex market.

Understanding how interest rates and the government bond market affect the valuation of a currency is very important. These factors are carefully monitored by experienced traders to determine long-term trends. Fluctuations in US Treasuries, especially Treasury yields, are one of the main factors in assessing US dollar movements that many novice traders tend to ignore.

A trader needs to be aware that changes in US Treasury yields have a direct impact on the valuation of the US dollar. Knowing how Treasury yields and other government bond yields affect the valuation of their respective currencies can be a powerful tool for currency traders.

What are government bonds?

Bonds are debt instruments that can be used by corporations and governments to access relatively low interest rates on borrowed funds. Bonds provide governments and corporations with a cheaper source of borrowing compared to other types of loans.

In the United States, the government issues bonds at the federal, state, and municipal levels.

The issuer of the bond usually sets the terms of the borrowing, which include the maturity period of the bond and the amount of periodic payments. At the subsequent bond auction, investors agree to pay a certain price for the bond, which then determines its average yield. Bond buyers typically receive coupon payments, which are basically interest on the amount of their investment. These payments are paid periodically, such as at intervals of 30 days, 60 days, 90 days, 120 days, 3 years, 5 years, 10 years and 30 years.

A bond's yield is the annual effective return, taking into account the price that was paid for the bond and the coupons that must be paid on it.

Additionally, the price of a bond refers to the amount paid by the buyer for the bond, or its current market valuation, while the coupon on a bond is the amount of interest that the bond buyer is periodically paid by the bond issuer for the use of the bond.

Note that the price of a bond is inversely related to its yield. When the price of a bond rises, the yield decreases, and when the price of a bond falls, the yield increases. This is an important concept for traders.

Typically, if investors are bearish on bonds, bond yields will rise and imply higher future interest rates, which are typical for the US dollar. If sentiment is bullish, yields decline and suggest lower future interest rates, which typically cause the US dollar to lose value.

US Government Notes, Bills and Bonds

Consider US Treasury bills and bonds, whose yields tend to have the greatest impact on the major currency pairs of the foreign exchange market, including the US dollar. Generally, notes have maturities of one year or less, notes have maturities of two to ten years, and bonds have maturities of ten to thirty years.

In addition, several additional bond-related terms need to be defined. In the bond market, the term “zero coupon” means that no coupons are paid on a debt instrument. Such assets are sold at a value below their “par value”.

For example, if a Treasury bill has a notional amount of $1,000, the investor will pay less than the face value for the bond and then receive the full $1,000 at maturity without receiving any coupon payments. For a six-month Treasury bill, if the original amount paid for the instrument was 98 percent of the face value, or $980, then the profit of $1,000 minus $980, or $20, would be an annualized return of four percent, excluding interest. .

Treasury bills have the shortest maturities and are always sold as zero-coupon instruments, as opposed to Treasury bills and bonds that have longer maturities and coupon payments. In addition, interest rates on government bonds are determined as a percentage of par for long-term debt instruments that have coupon payments, as is typically the case with Treasury notes and bonds. These coupons are paid periodically over the life of the financial instrument and result in a specified effective interest rate or yield that can be compared to prevailing market interest rates for similar periods.

The U.S. Treasury typically announces coupons on its bonds before a bond auction takes place. This is done so that investors can decide on the amount they want to pay for the bond. If the Treasury pays a coupon at prevailing interest rates, then investors can bid up the bonds and even bid above par, such as 101 or 102.

How will this affect the foreign exchange market? If foreign investors plan to purchase U.S. Treasuries at auction, they will also need to purchase U.S. dollars to purchase the bonds. This is the main reason that during “risk aversion” during times of geopolitical troubles, US Treasuries are bought up because they are considered such a safe investment and investors buy US dollars to do so. The US dollar therefore rises in value relative to the currencies of other countries due to increased demand for it.

Alternatively, when the mentality of international investors shifts towards increased risk appetite, the view on the price of US Treasuries will be bearish and cause them to rise. This is because such investors will have a preference for purchasing instruments that offer the highest yield, and such instruments are typically denominated in currencies other than the U.S. dollar.

Currencies that are often favored by investors with a higher risk appetite are high-yielding currencies such as the New Zealand and Australian dollars. These currencies offer higher interest rates, which offset the risk of their national currencies depreciating. The higher yields on these currencies and their government bonds are a form of compensation for taking on additional risk.

In high-risk environments, investors tend to want to protect their money. The currencies of choice during this period are the so-called “safe haven” currencies, which include the US dollar, Swiss franc and Japanese yen.

Demand for government bonds at auction

A key measure of demand for U.S. Treasury bills, notes and bonds is the “bid-to-cover ratio.” The bid-ask ratio always takes into account the volume of bonds that investors have bid for against the volume of debt securities actually offered for sale. For example, if the Treasury offers $10 billion of Treasury bills for sale at auction, and investors bid for $15 billion, then the bid-to-cover ratio would be 1.5.

A high bid-to-cover ratio means the auction was successful, and this will typically benefit the currency in question since investors will need to buy that currency in order to buy the bonds they are bidding on. This important information is published after all major Treasury auctions, as well as bond auctions in other countries.

Typically, the success of a Treasury auction is judged by how the current auction's bid-to-cover ratio compares to that of previous auctions. If an auction significantly outperformed previous auctions with a higher bid-to-cover ratio, then the auction will be considered a success.

Some analysts consider a Treasury auction to be extremely successful if it has a bid-to-cover ratio of 2.0 or more. Additionally, a negative price-supply ratio indicates low demand. This could lead to a weaker US in the foreign exchange market as fewer foreign investors buy dollars.

How do government bond prices affect the value of currencies?

Government bonds tend to have lower yields than other investment assets such as stocks. This is because coupon payments on government bond instruments are virtually guaranteed, making them considered a very safe investment.

Given this, corporate bonds and bonds issued by some shakier companies by governments may be at significant risk of defaulting on coupon payments or even principal repayments.

When risk aversion leads to a “flight to quality,” such investors tend to buy U.S. government bonds and their yields fall relative to other bonds in the financial markets. When this happens, the value of the US dollar rises and the relative value of other currencies usually declines.

As an example of how a currency's valuation relates to the prices of its corresponding government bonds when major economic data is released, consider the relationship between the 10-year US Treasury bill and the US dollar.

Following the release of much better-than-expected US retail sales data, the 10-year Treasury market tends to fall sharply, pushing bond yields higher.

Higher bond yields indicate the risk of higher interest rates in the US. In addition, high yield bonds attract foreign investors who sell their local currency to buy the US dollar to purchase the bonds. This causes the US dollar to rise against these currencies.

As noted in the previous example, government bond interest rates reflected in Treasury yields can have a significant impact on the value of the U.S. dollar. The following chart shows the typically strong correlation of the 10-year US Treasury yield with the US dollar relative to the Japanese yen exchange rate:

The chart also shows that as the 10-year US Treasury yield rises, there is a corresponding rise in the USD/JPY exchange rate. Conversely, when bond yields decline, USD/JPY typically declines as well. This highlights the positive correlation between government bond rates and the value of the US dollar, which in this case is 0.61.

Bond spreads, interest rate differentials and carry trades

Government bonds play a significant role in the foreign exchange market. With increased access to international markets and increasing differences in bond yields and interest rates, hedge fund managers remain open to investing in higher-yielding countries.

As an example of a carry trade, consider a situation where higher interest rates in Australia are five percent and interest rates in the United States are less than two percent. This significant difference in interest rates suggests an investment strategy that takes advantage of the difference in yield between the two major economies.

The most successful carry trades have a positive interest rate or carry, which involves buying a currency with a higher interest rate and selling a currency with a lower interest rate. And also combines directional trend strategies that will favor the higher interest rate currency over the expected investment horizon.

The combination of these two favorable conditions will take advantage of the direction of the currency held long when financing a trade with a short position in a low interest rate currency. This has led to huge profits for some traders, as was seen in 2000 when those trading long the Australian dollar against the US dollar.

When the spread between the US dollar and the Australian dollar began to widen in 2000, the Australian dollar began to rise within a few months. Then the difference in interest rates was 2.5% in favor of the Australian dollar, which over three years will lead to an increase in the AUDUSD currency pair by +37%. In addition to trading profits on the currency position, investors also received daily interest on the carry trade.

In addition to AUDUSD, the lower-yielding Swiss Franc and Japanese Yen, which were pegged to the high-yielding Australian and New Zealand dollars, were also frequently used to finance trades. The carry trade was particularly profitable in 2007, when Japanese bond yields were as low as half a percent and Australian bond yields reached 8.25 percent.

By the time of the global economic crisis in 2008, the international bond market had strengthened significantly. Many countries began to cut interest rates, which led to the unwinding of carry trade positions, which put significant pressure on the Australian and New Zealand dollars.

The popularity of the carry trade strategy has decreased significantly in recent years due to the narrowing of yield spreads of major currencies. However, some hedge funds, investment banks and other financial institutions still take advantage of interest rate differentials by entering into carry trades when they believe financial conditions are right to generate stable income.