The future direction of the yield curve is at the centre of economic news. Although Forex news is focused on Forex trading, interest rates are an important contributor to the attractiveness of a currency. As the yield curve shows the interest rates over different maturities, it is important for retail Forex traders to understand it.
The yield curve is actually a line of joined up dots. Each dot displays the interest rate at a particular maturity date. When these different maturities are joined up, a line which is usually curved upwards is displayed. This is the yield curve. It is curved upwards due to the risk reward relationship, the longer money is borrowed for, the higher the return should be. There is also a relationship to inflation expectations. When the curve is slopping upwards (as above) it is seen as normal. Many of you will know that finance has been turned upside down by central bank policies. This has had an effect on the yield curve…
As the yield curve is actually several maturities joined up together, each dot is pricing in a different interest rate expectation. As interest rates are not linear, the expectation of where they will be over the years changes. This is exhibited by the curve in the line of joined up dots! In effect it has segments to it, with each segment having its own story.
Central bank money policies are a key driver influencer of the yield curve through their setting of interest rates. As a result of the power they have, monetary policy meetings are followed closely. The minutes which are distributed in the weeks after the meetings, are read carefully for any difference in the tone of language used. The tone of this language is important as it guides markets as to what central banks are thinking.
The yield curve also acts as barometer of danger. If it slops upwards, then all is right with the world. On the other hand, if it slopes downwards over time, i.e. it is cheaper to borrow over several years than one or two, then something is wrong. This is called the Inverted yield curve. This occurs when investors expect economic growth to slow markedly or even disappear. As a result they all ‘rush to safety’ by buying safe assets such as the US 10 year treasuries. This event has always been followed by a recession, as a result it is seen a newsworthy when it happens. What it cannot do is predict when this recession will occur!
As a result of the inverse relationship between bond prices and yields, the more investors buy bonds, the higher their price and lower their yield. This puts pressure on the yield curve by forcing the longer-term segment to it to slope downwards, inverting itself. An inverted yield curve is considered a warning to an impending recession. It can take months for this recession to appear, but it has so far never inverted without a recession the occurring.
It is difficult to establish a clear link between Forex trading and the yield curve but there are some interesting observations to highlight. In the previous paragraph we mentioned that it inverts as investors rush to safety. One of the safest assets is the US 10 year treasury. For investors who do not regularly hold US Dollars, this means having to buy Dollars. In times of stress in financial markets, the US dollar increases markedly as investors buy its ‘safe haven’ status.
Also, how currency pairs behave towards each other is important. If a currency is yielding more in interest than another it will often be seen as more attractive due to the greater return. This return will come in the form of interest but also the capital growth, as more investors buy this currency, seeking the interest yield. The US dollar being one of the highest yielding currencies of recent years, explains why it has also been so strong. When one currency yields more than another, this can lead to carry trades, namely borrowing in one currency to earn a return in another.
Such a subject has entire economics books written on it, such can be its complexity and the importance in our financial system. The key is understanding the interest rate expectations as these are what causes it’s sloping up and down. You can stay aware of potential changes by being aware of a change in the tone of language from a central bank or by following important data releases. This will place you in a position to profit, through your increased knowledge at the expense of others who have not done their homework!