Once you know how and why bonds are so closely related to forex, we need to take a closer look at bond prices and yields. A currency’s value is determined by what you can buy with it. And since most of the currency moves that affect forex are related to buying bonds, understanding bond pricing is useful for forex trading.
As you know, a bond is a commitment to pay back a certain amount of money on a certain date in the future, and it can be sold. Like currencies, you can sell bonds on the spot market (that is, for delivery within two days.) You can also sell them as futures, depending on where investors think bond prices will be in the future. Both of these can move currency markets.
Why Do Bond Prices Change?
Let’s go through the process of issuing a bond to understand bond prices and how to determine the yield.
A certain entity, a government or business, needs money. Therefore, it decides to borrow it by selling a bond. Let’s say, $10,000, which they promise to pay back in one year.
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The bond has a face value of $10,000 + interest. You can pay the interest in coupons at a fixed time, but let’s not make things unnecessarily complicated. Let’s say. the interest rate is at 1%. That would be the “first issuance.” And if you bought the bond, you’d be entitled to receive $10,100 after one year.
But, let’s say you need the money sooner. You can’t redeem the bond from the seller, because the commitment was to pay in one year. So, you sell it to someone else. Depending on the supply and demand for that bond, the price can be different.
If the bond is really popular, people might be willing to pay more than the face value of the bond. We call this trading at a premium.
You might be able to sell your $10,000 at a premium of $30 (0.3%). However, that means the yield for the person who bought it has gone down. This is because the issuer will only pay the face value plus interest when the year is up.
So, at the first issuance, the yield on the bond was 1% (you’d get 1% more than the money you bought it for.) But the new buyer, who paid $10,030 for the bond, will get back $10,100 when the year is up. So he’s only going to make $70 on his investment, or 0.7% yield. Demand for the bond causes the price to go up, and the yield to go down.
On the other hand, if the bond is not popular, you might not be able to sell it at the full face value. And we call this trading/selling at a discount. You might only be able to sell your $10,000 at a discount of $40, or $9,960. But, when the buyer goes to redeem the bond when the year is up, he’s still going to get $10,100. Therefore, the yield for him is 1.4%. Excess supply or drop in demand causes the price of the bond to go down, while the yield rises.
This is why while the interest rate on the bond remains fixed, the yield can change with the market. Typically, for the government which is constantly and regularly issuing bonds, the yield will translate into the effective interest rate next time they auction off bonds.
How Currencies are Influenced
The issuance of bonds, or their being bought up by the central bank, for example, changes the demand in the markets. This, in turn, affects the yield. If a central bank starts buying bonds, then the demand increases, and the yield goes down.
With lower yields, they are a less attractive investment, so foreign investors are less likely to buy the currency to be able to buy the bonds. And that, in turn, weakens the currency.
Foreign investors also care about the value of the currency while they hold the bonds. So, if they buy a bond with a yield of 1%, for example, but the currency loses 2% in value over that time… they’ve effectively lost money. On the other hand, if they buy a bond with no yield or even negative yield, but the currency goes up in the meantime, then they’ve made money.
The bond curve is predictive of where investors expect interest rates to be in the future. And because bonds and currencies are linked, it is predictive of the value of the currency as well.