The global markets are becoming more and more interconnected. We often see the prices of commodities and futures impact the movements of currencies, and vice versa. The same can be seen in the relationship between currencies and bond spreads (the difference between countries' interest rates); the price of currencies can impact the monetary policy decisions of central banks around the world, but monetary policy decisions and interest rates can also affect the price action of currencies. For example, a stronger currency helps to hold down inflation, while a weaker currency will fuel inflation. Central banks take advantage of this relationship as an indirect means to effectively manage their respective countries' monetary policies.

By understanding and observing these relationships and their patterns, investors have a window into the currency market, and thereby a means to predict and capitalize on the movements of currencies.

What Does Interest Have to Do With Currencies?
We can look at history to see an example of how interest rates play a role in currencies. After the burst of the tech bubble in 2000, traders became risk averse and went from seeking the highest possible returns to focusing on capital preservation. But since the U.S. was offering interest rates below 2% (and these were headed even lower), many hedge funds and investors with access to the international markets went abroad in search of higher returns. Australia, which had about the same risk factor as the U.S., offered interest rates in excess of 5%. As such, it attracted large streams of investment money into the country and, in turn, assets denominated in the Australian dollar.

Large differences in interest rates between countries allow traders to use the carry trade, an interest rate arbitrage strategy that takes advantage of the interest rate differentials between two major economies, while aiming to benefit from the general direction or trend of a currency pair. This strategy involves buying one currency that's paying a high interest rate and funding it with another that is paying a low interest rate. The popularity of the carry trade is one of the main reasons for the strength seen in pairs such as the Australian dollar and the Japanese yen (AUD/JPY), the Australian dollar and the U.S. dollar (AUD/USD), and the New Zealand dollar and the U.S. dollar (NZD/USD). (For mor insight, see Profiting From Carry Trade Candidates.)

However, it is often difficult and expensive for individual investors to send money back and forth between bank accounts around the world. The relatively high retail spread on exchange rates can offset any potential yield they are seeking. On the other hand, large institutions such as investment banks, hedge funds, institutional investors and large commodity trading advisors (CTAs) generally have the scale to command lower spreads. As a result, they shift money back and forth in search of the highest yields with the lowest sovereign risk (or risk of default). When it comes to the bottom line, exchange rates move based on changes in money flows.

The Insight for Investors
Retail investors can take advantage of these shifts in flows by monitoring yield spreads and the expectations for changes in interest rates that may be embedded in those yield spreads. The following chart is just one example of the strong relationship between interest rate differentials and the price of a currency.

Figure 1

Notice how the blips on the charts are roughly mirror images. The chart shows us that the five-year yield spread between the AUD and the USD (represented by the blue line) was declining between 1989 and 1998. At the same time, this coincided with a broad sell-off of the Australian dollar against the U.S. dollar.
When the yield spread began to rise once again in the summer of 2000, the AUD/USD followed suit with a similar rise a few months later. The 2.5% spread of the AUD over the USD over the next three years equated to a 37% rise in the AUD/USD. Those traders who managed to get into this trade not only enjoyed the sizable capital appreciation, but also earned the annualized interest rate differential.
This connection between interest rate differentials and currency rates is not unique to the AUD/USD; the same sort of pattern can be seen in numerous currencies such as the USD/CAD, NZD/USD and the GBP/USD. The next example takes a look at the interest rate differential of New Zealand and U.S. five-year bonds versus the NZD/USD.

Figure 2

The chart provides an even better example of bond spreads as a leading indicator. The interest rate spread bottomed out in the spring of 1999, while the NZD/USD did not bottom out until over one year later. By the same token, the yield spread began to steadily rise in 2000, but the NZD/USD only began to rise in the early fall of 2001. History shows that the movement in interest rate difference between New Zealand and the U.S. is eventually mirrored by the currency pair. If the interest rate differential between New Zealand and the U.S. continued to fall, then one could expect the NZD/USD to hit its top as well.
Other Factors of Assessment
The spreads of both the five- and 10-year bond yields can be used to predict currency movements. The rule of thumb is that when the yield spread widens in favor of a certain currency, then that currency will tend to appreciate against other currencies. But even though currency movements are impacted by actual interest rate changes, they are also affected by the shift in economic assessment or plans by a central bank to raise or lower interest rates. The chart below demonstrates this point.

Figure 3

According to Figure 3, shifts in the economic assessment of the Federal Reserve tend to lead to sharp movements in the U.S. dollar. In 1998, when the Fed shifted from an outlook of economic tightening (meaning the Fed intended to raise rates) to a neutral outlook, the dollar fell even before the Fed moved on rates (note that on July 5, 1998, the blue line plummets before the red one). A similar movement of the dollar was seen when the Fed moved from a neutral to a tightening bias in late 1999, and again when it moved to an easier monetary policy in 2001. In fact, once the Fed began considering loosening monetary policy and lowering rates, the dollar reacted with a sharp sell-off.
When Using Interest Rates to Predict Currencies Will Not Work
Despite the various scenarios in which this strategy for forecasting currency movements does tend to work, it is certainly not the Holy Grail to making money in the currency markets. There are a number of other scenarios and mistakes traders can make that may cause this strategy to fail. The two most common are impatience and excessive leverage.
As indicated in the examples above, these relationships foster a long-term strategy. The bottoming out of currencies may not occur until a year after interest rate differentials may have bottomed out. If a trader cannot commit to a time horizon of a minimum of six to 12 months, the success of this strategy may decrease significantly.
Too Much Leverage
Traders using too much leverage may also be ill-suited to the broadness of this strategy. Since interest rate differentials tend to be fairly small, traders tend to want to increase the leverage to increase the interest rate return. For example, if a trader uses 10 times leverage on a yield differential of 2%, it would effectively turn an annual rate of 2% into 20%, and the effect would increase with additional leverage. However, excessive leverage can prematurely kick an investor out of a long-term trade because he or she will not be able to weather short-term fluctuations in the market.
Although there may be risks to using bond spreads to forecast currency movements, proper diversification and close attention to the risk environment will improve returns. This strategy has worked for many years and can still work, but determining which currencies are the emerging high yielders versus which currencies are the emerging low yielders may shift with time.

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