The exchange rate between different currencies can be influenced by a number of factors. One of those factors is the bond spread between two countries. This is the difference between the interest rate offered on the bonds of one country, and the interest rate offered on the bonds of another. In this article, we’ll discuss how exchange rates are affected by bond spreads.

If you monitor the bond spreads between various countries, you might get some clues about where their currency pair is headed.

Here is an example:

How Exchange Rates are Affected by Bond Spreads

When the bond spread widens, the currency with the bonds paying a higher interest rate is likely to appreciate in value. The currency with the lower rates may fall in value. Thus, you might be able to predict where certain currency pairs are likely to trade based on this information.

You can see this play out between the Australian Dollar and the U.S. Dollar. The bond spread between the two rose from -50% to -5% between 2002 and 2004. During that same period of time, the Australian Dollar increased almost 50% against the dollar, from 0.5000 to about 0.7000. It happened again in 2007, when the spread went from -60% to +55% and the value of the AUD climbed by almost 2,000 pips against the USD.

However, the AUDUSD reversed course with the recession of 2008, as traders started to take advantage of the carried trade and wanted to cash in on the wide difference in interest rates offered between the AUD and USD.

To see one more example of how exchange rates are affected by bond spreads, check out this chart:

How Exchange Rates are Affected by Bond Spreads

In general, you can see that when the bond spread between the UK bond and the US bond drives lower, the GBPUSD weakens also. When the bond spread drives higher, usually the GBPUSD price does also.

 

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