Now, let me talk about the other kind of gold… the black one.
As you may know, crude oil is often referred to as the “black gold” or as we here at BabyPips.com like to call it, “black crack.”
One can live without gold, but if you’re a crack addict, you can’t live without crack.
Oil is the drug that runs through the veins of the global economy as it is a major source of energy.
This means that Canada is United States’ main black crack dealer!
Because of the volume involved, it creates a huge amount of demand for Canadian dollars.
Also, take note that Canada’s economy is dependent on exports, with about 85% of its exports going to its big brother down south, the U.S. Because of this, USD/CAD can be greatly affected by how U.S. consumers react to changes in oil prices.
If U.S. demand rises, manufacturers will need to order more oil to keep up with demand. This can lead to a rise in oil prices, which might lead to a fall in USD/CAD.
If U.S. demand falls, manufacturers may decide to chill out since they don’t need to make more goods. Demand in oil might fall, which could hurt demand for the CAD.
Oil has a negative correlation with USD/CAD.
When oil goes up, USD/CAD goes down. When oi goes down, USD/CAD goes up.
So, the next time you gas up your car and see that oil prices are rising, you can use this information to your advantage! It may be a clue for you to go short on USD/CAD!
How Bond Yields Affect Currency Movements
A bond is an “IOU” issued by an entity when it needs to borrow money. These entities, such as governments, municipalities, or multinational companies, need a lot of funds in order to operate so they often need to borrow from banks or individuals like you. When you own a government bond, in effect, the government has borrowed money from you.
You might be wondering, “Isn’t that the same as owning stocks?”
One major difference is that bonds typically have a defined term to maturity, wherein the owner gets paid back the money he loaned, known as the principal, at a predetermined set date. Also, when an investor purchases a bond from a company, he gets paid at a specified rate of return, also known as the bond yield, at certain time intervals. These periodical interest payments are commonly known as coupon payments.
Bond yield refers to the rate of return or interest paid to the bondholder while the bond price is the amount of money the bondholder pays for the bond.
Now, bond prices and bond yields are inversely correlated. When bond prices rise, bond yields fall and vice-versa. Here’s a simple illustration to help you remember:
Wait a minute… What does this have to do with the currency market?!
Always keep in mind that inter-market relationships govern currency price action.
In this case, bond yields actually serve as an excellent indicator of the strength of a nation’s stock market, which increases demand of the nation’s currency.
For example, U.S. bond yields gauge the performance of the U.S. stock market, thereby reflecting the demand for the U.S. dollar.
Let’s look at one scenario: Demand for bonds usually increases when investors are concerned about the safety of their stock investments. This flight to safety drives bond prices higher and, by virtue of their inverse relationship, pushes bond yields down.
As more and more investors move away from stocks and other high-risk investments, increased demand for “less-risky instruments” such as U.S. bonds and the safe-haven U.S. dollar pushes their prices higher.
Another reason to be aware of government bond yields is that they act as an indicator of the overall direction of the country’s interest rates and expectations.
For example, in the U.S., you would focus on the 10-year Treasury note. A rising yield is dollar bullish. A falling yield is dollar bearish.
It’s important to know the underlying dynamic on why a bond’s yield is rising or falling. It can be based on interest rate expectations or it can be based on market uncertainty and a “flight to safety” to less-risky bonds.
After understanding how rising bond yields usually cause a nation’s currency to appreciate, you’re probably itching to find out how this can be applied to forex trading. Patience, young padawan!
Recall that one of our goals in currency trading (aside from catching plenty of pips!), is to pair up a strong currency with a weak one by first comparing their respective economies. How can we use their bond yields to do that?
The bond spread represents the difference between two countries’ bond yields.
These differences give rise to carry trade, which we discussed in a previous lesson.
By monitoring bond spreads and expectations for interest rate changes, you will have an idea where currency pairs are headed.
Here’s what we mean:
As the bond spread between two economies widens, the currency of the country with the higher bond yield appreciates against the other currency of the country with the lower bond yield.
You can observe this phenomenon by looking at the graph of AUD/USD price action and the bond spread between Australian and U.S. 10-year government bonds from January 2000 to January 2012.
Notice that when the bond spread rose from 0.50% to 1.00% from 2002 to 2004, AUD/USD rose almost 50%, rising from .5000 to 0.7000.
The same happened in 2007, when the bond differential rose from 1.00% to 2.50%, AUD/USD rose from .7000 to just above .9000. That’s 2,000 pips!
Once the recession of 2008 came along and all the major central banks started to cut their interest rates, AUD/USD plunged from the .9000 handle back down to 0.7000.
So what happened here?
One factor that is probably in play here is that traders are taking advantage of carry trades.
When bond spreads were increasing between the Aussie bonds and U.S. Treasuries, traders load up on their long AUD/USD positions.
To take advantage of carry trade!
However, once the Reserve Bank of Australia started cutting rates and bond spreads began to tighten, traders reacted by unwinding their long AUD/USD positions, as they were no longer as profitable.