Understanding the Bond Market to Navigate the Currencies.

When I started trading, interest rates were very low, inflation was low and if anything the overall environment was one of disinflation. As a consequence (although still important) the bond market was not a main driver of the market.

Fast forward 11 years and the 'post covid lockdown era' has put the spotlight back on bonds.

So, I thought it appropriate to offer my take on how bonds affect the market as a whole and in particular, the currencies.

The correlation is:

Rising bond yield = rate hike expectations.

Falling bond yield = rate cut expectations.

But it is very import to ask: Why is the yield Rising or falling? And to put it into context with the current market environment.

The key thing to remember in all of this is: In a perfect world, inflation should grow at a steady 2% year on year. I don't know why 2% is the ideal number, people far cleverer than I have decided that 2% is perfect for steady, sustainable growth. And I'm happy to default to that.

Why is inflation important? It honestly goes without saying but I'm going to say it anyway.

Over the last couple of years, the price I pay for a box of pet food has risen from £3 to £5. That doesn't sound an awful lot, but it's a 66% rise, my income hasn't risen 66% over the last couple of years. So when I add that pet food purchase to multiple necessary purchases, which have also risen significantly. At some point I'm going to have to make cut backs.

I'm just one person, but when a population has to make cut backs, we get growth concerns. And growth concerns can quickly turn into a recession concerns, or even worse, an actual recession.

That was a long-winded way of me saying that inflation drives market sentiment. And it's depicted via bond yield.

Which is why we need to understand the context by asking why. Why are bond yields doing what they are doing?

Because there is a different market outcome depending on the permutation.

It could be:

Rising bond yield = negativity

This is probably the situation we find ourselves in today. How much further can Interest rates rise before we get slowing growth?

But, it could be:

Rising yield= positivity.

All is well, the population is comfortably spending money and interest rates need to rise a little bit to keep inflation at 2%.

On the opposite end of the spectrum, we could get:

Falling yield = Negativity.

Growth concerns have kicked in and interest rates need to fall to stop a recession.

Or:

Falling yield = positivity

Concerns the interest rate will have to rise too much have subsided. The market thinks it's good news that interest rates could fall.

How does this tie in with the currencies?

In its simplest form, the bond market will tell us if the mood is 'risk on' or 'risk off'. And the currencies will follow according to each currencies own correlation to the risk environment.

In times of risk on: The currencies that 'usually' benefit are AUD, NZD, GBP, CAD. The EUR and USD often also benefit in a risk on environment.

In times of risk off: The currencies that 'usually' benefit are JPY, CHF, USD. The EUR can also act as a safe haven currency in times of risk off. The CAD can also benefit from a negative environment if the price of oil is high.

Another scenario might be, if YIELDS are moving but we don't have an 'extreme risk environment'. Which is the environment I think we've been in recently. Yields have been going up but we've not had either a very positive or very negative story to accompany the rise.

In that scenario, the currencies movement defaulted to a direct correlation between actual interest rate differential. Meaning the currency with the lowest yielding interest rate, with no future rate hikes on the agenda (the CHF) was the weakest currency at the time.

That's just two permutations, there are others, and that's the reason I ask: What is the bond markt doing? What are the implications for the overall market risk environment? And how the the currencies reacting?

When I have the answer to those questions, I can form a bias on the near term direction of the currencies.

Unfortunately, correlations are not apparent 100% of the time. But when it's clear and obvious, that's when I have the highest conviction in my trading decision.

*It's worth noting that not long ago, the S&P 500 could also be used alongside bonds for double conformation of the environment. There are still times the is the case. But currently, the S&P seems impervious and wants to carry on up regardless. I suspect this could remain the case whilst US unemployment data remains historically low. So, although I do look at the S&P on a daily basis, it's not currently in the markets driving seat. Which I why for the time being, I put most of the emphasis on bonds.

Please feel free to email any thoughts or questions: johnelfedforexblog@gmail.com