The bond market and currency prices

Currencies are the basic building blocks of all economic activity. A grocery, a military contractor, a mortgage borrower, and even gangsters evaluate their economic plans in terms of currencies. Consequently, the forex universe encompasses all the other fields of financial activity including the bond, commodity and stock markets.

Most traders possess at least a basic conception of the relationship between forex and the stock markets. As large amounts of money is injected into the stock market, the resulting currency flows cause the value of currency pairs to fluctuate simultaneously. Similarly, commodity market trends have an easily demonstrable impact on the short term fluctuations of commodity currencies, and a slightly less clear impact on those of others. The same dynamics that cause these markets to influence currency quotes also ensure that fluctuations in the bond market affect the short and long term dynamics of the forex market powerfully, but there are also certain aspects peculiar to the bond market which we’ll try to examine in this article.

The bond market is very large, with the US treasury market reaching a size of about 10.7 trillion dollars as of December 2008. Needless to say, bonds are not issued by government entities alone, as townships, corporates, and many other types of institutions regularly issue their own papers to benefit from this vast and liquid market. Actors in the US treasury and corporate bond markets range from small individual savers to foreign governments with gigantic amounts to spend, and the impact of all kinds of economic developments is felt in the bond market on a daily basis.

What is the use of the bond market? For buyers of corporate bonds, the purpose is benefiting from the various yield options available while controlling risk exposure through bond ratings, and the maturity term of the paper bought. As bond investors are always higher in the payment structure in case of default or bankruptcy, many investors and traders choose to purchase bonds in place of stocks in order to achieve a favorable balance between risk and yield. Purchasing the bond of a corporation allows us to benefit from the growth of the firm while taking minimal risk, but at the same time minimizes our control over the capital lent, since bond investors have no say in how the management of a firm uses the borrowed funds. The significance of the corporate bond market is more limited for the retail forex trader than that of the treasury market. On the other hand, as corporate bond rates are powerful indicators of risk perception in the markets in general, the forex trader is well-advised to adjust his leverage in response to spikes in the rates of speculative, or low level investment grade corporate bonds. If sustained, such spikes would have long-lasting and deeper consequences for the economy at large, and recessions are often preceded by turmoil in the corporate bond market.

The role of the government bond market is different in a number of ways. First of all, we must keep in mind that, as long as a government possesses the legal right to create money, it is in no danger of defaulting on its obligations. Consequently, if there is anywhere a risk-free investment, it is clear that a government bond is the most credible candidate. Secondly, since government bonds are almost certain to be paid in time, they serve as a general benchmark against which all other kinds investments are measured. The success or failure of a professional money manager, for instance, is not measured in the absolute value of dollar gains or losses, but in comparison to the yield on the treasury bond of a comparable term. This method is useful because it allows us to evaluate the risk/reward ratio of an investment in a much more constructive way: if by holding a three-month government bond we can achieve greater returns than that offered by our forex manager, what is the point of investing anyway? Thirdly, the government bond market finances the spending of governments. Thus, fluctuations in this market have far greater significance for the value of a currency, since the changes directly influence the credibility of the government’s policies, and the sustainability of its deficits. And finally, since bond yields are strongly dependent on inflation, and inflation is closely related to growth, the term-yield structure of the government bond market provides a very powerful early warning system for predicting periods of boom and bust.

Forex traders with some experience will be quick to recognize the intra-day relationship between treasury bond yield, stock prices, and currency values. This is not surprising, since in many cases, the fluctuations in the value of a currency represents the movements of foreign investors between bonds and stocks as the events of the day progress. In addition, the strong relationship between inflation expectations and bond yields makes government bond yields a very useful indicator for evaluating the financial world’s opinion on the success or failure of US Federal Reserve in controlling inflation. As inflation is a significant component of the equation that decides currency values, the importance of the data provided by the treasury market is evident. But beyond all the short term sound and fury, developments in the bond market have important long term implication for currency trends too. As an important component of the financial account, external flows into bonds have a direct role in establishing long-term currency trends. The fact that the US dollar still has not collapsed in spite of the massive spending and borrowing of the US government is in part explained by the continued health, at least on surface, of the US Treasury market. We hope to return back to this subject in future articles, and examine the bond market in greater detail.