The Yield Curve and Forex: How Bond Yields Lead Currencies

A bond, in the four facts that matter

A bond is a loan you can trade. A government or a large company borrows, and in return promises to pay a fixed amount each year and to return the principal at the end.

Why they are issued — to borrow at scale from many lenders at once, over a term the borrower chooses, rather than negotiating with a bank.
Who issues them — governments and large corporations. Government bonds from major economies are treated as the closest thing to a risk-free asset, which is why their yields anchor everything else.
Face value and coupon — the amount repaid at maturity, and the fixed payment made each year. Both are set when the bond is issued and neither ever changes.
Nominal against real — the coupon is nominal. Subtract inflation and you have the real return, which is what actually competes with gold and with equities.

Price and yield move opposite ways, always

This is the mechanical fact the rest of the lesson is built on, and it is worth being able to derive rather than remember.

Take a bond with a face value of 100 paying a coupon of 5 a year. Bought at issue for 100, it yields 5 per cent. If demand for it falls and its price drops to 80, the coupon is still 5 — so the buyer at 80 is receiving 5 on an outlay of 80, a yield of about 6.25 per cent. If instead demand rises and the price goes to 125, that same 5 is a yield of 4 per cent.

Nothing about the bond changed in any of those cases. Only what somebody paid for it. So bond prices up means yields down, and every headline about a "bond rally" is a headline about falling yields.

A bond with a fixed coupon shown at three prices, with the yield rising as the price paid for it falls — One bond, three prices, three yields. This is why a flight to safety — everyone buying bonds — pushes yields down and takes the currency with them. Click to enlarge

The curve, and what its shape is forecasting

Plot the yield of a government's bonds against how long each has left to run — two years, five, ten, thirty — and the line through them is the yield curve.

Because a long yield is effectively what the market expects short rates to average over that whole period, the shape is a forecast rather than a description.

Normal — longer maturities yield more, compensating for time and uncertainty. Ordinary conditions, growth expected.

Flat — the market is unsure, or is in the middle of changing its mind. Often the transition rather than a state.

Inverted — short maturities yield more than long ones, which sounds absurd until you read it as a forecast: it says the market expects rates to be lower in future than they are now, and rates are cut when the economy is weak.

Inversion has preceded most modern recessions. Two cautions belong with that sentence and are usually missing. It precedes, which is not the same as causes; and the lag has run from a few months to over two years, which makes it useless as a timing tool and valuable as a context one.

A normal upward yield curve, a flat curve and an inverted curve where short maturities yield more than long ones — The shape is the market's forecast of its own future rates. Inversion is that forecast saying cuts are coming — eventually. Click to enlarge

The spread, and the pairings that make it tradeable

In practice the curve is watched as a single number: the gap between two maturities. Ten-year minus two-year is the one quoted most, with ten minus thirty behind it. When that spread goes negative the curve has inverted.

The source pairs it directly with instruments, and these are the charts worth rebuilding for yourself:

The US ten-year against the dollar index, with an FOMC meeting marked. The yield moves first and the dollar follows — which is lesson seven's discovered rate arriving before the set one.
The US ten-year against AUD/USD, through a gap higher and the crossing of the 1.30 per cent area. A rising US yield pulls capital toward the dollar and away from the resource currency on the other side.
The US ten-year against gold, diverging at the 1.70 per cent line. Gold pays nothing, so a rising real yield is a direct competitor — this is the mechanism behind the inverse correlation of lesson six.
USD/JPY against the ten-year minus two-year spread, diverging at 1.60 per cent. The yen is a reserve instrument from lesson three, so it strengthens exactly when the curve is saying trouble.
The S&P 500 against the same spread — the equity market and the curve disagreeing is one of the more reliable signs that one of them is early.

The same idea between two countries

A curve is one country's forecast of itself. Put two countries side by side and you have something that prices a currency pair directly.

Deck seven does this with the British and German ten-year yields from the start of 2021, and then plots the gap between them against EUR/GBP. The reasoning is one sentence: money moves toward the higher yield, so when gilts start paying more relative to bunds, capital moves toward sterling and EUR/GBP falls.

This generalises to every major pair, and it is the most directly usable thing in the lesson. For any pair, plot the two countries' ten-year yields, subtract one from the other, and put the result above the pair. What you are looking for is not correlation but divergence — the moments when the spread has moved and the pair has not yet followed.

The gap between two countries ten-year yields plotted above the currency pair that connects them, with the pair following the gap — The spread is not a signal on its own. It is a level the pair is usually near, and the trade is in the gap between them. Click to enlarge

What to take from this one

Three things:

Bond prices and yields move opposite ways, because the coupon is fixed. A flight to safety buys bonds, which lowers yields, which weakens the currency — the opposite of the intuitive answer.
The curve is the market forecasting its own future rates. Inversion precedes recessions with a lag long enough that it is context, not a trade.
The yield gap between two countries is the cleanest fundamental input to their currency pair. Watch the gap, and trade the times the pair has not caught up.

Next: trading the decision itself

Open market operations, reserve requirements and the discount rate — and what happened to three currency pairs on the days their central banks moved.

Back to the twelve lessons

The yield curve, and how bonds lead currencies