It’s well known that currencies are closely linked to interest rates movements. The reason of this relationship is pretty simple: higher interest rates tend to attract foreign investment, increasing the demand and value of the currency. On the other hand, lower interest rates tend to be less attractive for foreign investment and decrease the currency's value.
Currencies are traded in pairs, for example EUR/USD, AUD/CAD, EUR/JPY and so on. So, in order to visually see the relationship between interest rates and currencies you need to take the difference between the respective country’s bond yields and the corresponding FX pair.
Let’s see an example with EUR/USD. Since you have the EUR as the base currency, you need to take the yield on the German bond (which is used as benchmark for the Euro Area) and since you have the USD as the quote currency, you take the US bond yield. The difference between the yield on the German bond and the US one gives you the yield spread. See the chart below.
Now you just need to compare it with the EUR/USD price chart to see the relationship and you will notice that the yield differential leads the price of EUR/USD. See the chart below.
The divergence between the yield spread and the EUR/USD price chart often led to big swings as the exchange rate caught up with the yield spread at some point. There can be many reasons in the short-term affecting the currency pair but in the long term it follows the yield spread. See the chart below with the divergences highlighted with boxes.
Divergences between yield spread and EUR/USD price
Don’t trade just based on the charts and correlations but look for reasons and keep yourself informed on the latest developments in the world. Yields will move based on macro fundamentals, so you should be aware of that and when you see a divergence that is not supported by fundamentals, be prepared to strike as soon as the short term aligns with the long term.
This article was written by Giuseppe Dellamotta.
