Tracking Bond Yields and Their Impact on Currencies

In March 2021, the yield on US 10-year Treasury bonds reached 1.74%, a level last seen in January 2020. This movement has captured the attention of investors and traders who closely monitor bond yields and their relationship with currencies. Let’s explore why yields rose and how they correlate with currency movements, offering valuable insights for forex traders.

Why Did US Bond Yields Rise?

At the onset of the pandemic in March 2020, the Federal Reserve lowered its benchmark interest rate to support economic activity. The Fed aimed to prevent a collapse in output across sectors and has stated it will not raise rates unless inflation exceeds the 2% target. However, rising inflation in early 2021 made investors nervous about potential rate hikes. In response, they sold off fixed-income securities in favor of higher-yielding assets, causing Treasury prices to decline and yields to rise.

While yields peaked at 1.74% in March 2021, they later cooled off as the Fed reassured markets of its commitment to controlling inflation without raising rates.

How Did the US Dollar Respond?

The year 2020 saw significant volatility in the US dollar due to the pandemic. The currency initially crashed in March 2020 as infections surged but quickly recovered as investors sought its safe-haven appeal. The US Dollar Index (DXY) jumped 8% from its March 9 lows to a high of 102.99 on March 20, driven by global uncertainty around virus waves, vaccine rollouts, and economic recovery.

In March 2021, as US Treasury yields rallied, the DXY rose alongside, climbing from 90 to 93. This raises questions about the link between Treasury yields and the US dollar, and how traders should position themselves during such fluctuations.

The Correlation Between Bond Yields and Currencies

Economic Activity as the Foundation

The performance of a country’s domestic economy directly affects the demand for its currency. Stable economies with robust capital markets attract foreign investment, boosting currency demand. When investors buy into a country’s economy, they sell other currencies, increasing the exchange rate of the target currency.

For example, in 2019, the EUR/USD pair declined due to weak economic conditions in the Eurozone. A recession in Italy, Gilet-Jaunes protests in France, prolonged Brexit uncertainty, and Germany’s slowing GDP growth (0.6% in 2019 versus 2.5% in 2017) made the euro less attractive. Consequently, the EUR/USD pair lost 3.6% by year-end.

Central banks play a significant role in this dynamic. When economic activity slows, they adopt monetary easing measures, such as purchasing government Treasuries and corporate bonds. This lowers bond yields (as bond prices rise) and increases the money supply, weakening the currency’s exchange rate. Conversely, when economies recover, central banks raise interest rates to prevent overheating and curb inflation. Higher interest rates push up both bond yields and currency values.

Direct Relationship Between Bond Yields and Currencies

Beyond economic activity, bond yields have a more immediate impact on currency movements due to investment behavior. Higher bond rates and lower bond prices attract foreign investors, increasing the demand for the country’s currency. The interest rate differential between two countries determines the appeal of holding one country’s bonds over another. This creates an opportunity for carry trade, where investors borrow in low-interest-rate environments to invest in higher-yielding markets, driving currency movements.

What It Means for Forex Traders

Forex traders are less concerned with a currency’s present value and more focused on its potential movement. Monitoring yield spreads or rate differentials can provide insights into future currency trends.

Example: EUR/USD and Yield Spreads

The 10-year German Bund versus the 10-year US Treasury yield spread historically correlates with the EUR/USD exchange rate. When German Bund yields rise relative to US Treasury yields, the euro attracts foreign capital, increasing its demand and boosting the EUR/USD pair.

Important Considerations

1. EU Economies Influence the Euro
   While Germany is a significant driver, the euro’s value is influenced by other EU member states, adding complexity to EUR/USD predictions.
2. Safe-Haven Status of the US Dollar
   The US dollar enjoys organic demand due to its safe-haven asset status. This is supported by the perceived low default risk of US Treasuries and the dollar’s role as an international reserve currency, which ensures persistent global demand.
3. Additional Factors Driving Forex Rates
   Forex rates are influenced by trade flows, macroeconomic conditions, and market speculation. For example, the Australian dollar appreciated in the last decade primarily due to the mining sector’s attractiveness, despite low interest rates. Additionally, the US dollar’s performance often reflects external economic activity, such as increased demand for imports or reduced global interest in US exports.

These factors can cause deviations between interest rate differentials and forex rates, depending on how persistent the other influencing factors are.

Conclusion

For forex traders, bond yields and interest rates serve as valuable signals of currency movements. However, traders must also consider broader economic, trade, and speculative factors to form a well-rounded strategy. By combining yield trends with a holistic analysis, traders can better position themselves in a volatile forex market.