A bond is a “loan” issued by an entity when it needs to raise funds. These entities, such as governments, municipalities, or multinational companies, require large amounts of capital to operate, so they need to borrow from banks or individuals like you. When you own government bonds, the government actually borrowed money from you.
You may be wondering, “Is this the same as owning a stock?”
The main difference is that the bond has a certain maturity time, and when the scheduled time expires, you can get back the borrowed money, which is the principal. Similarly, when an investor buys bonds from a company, at regular intervals, he can get a certain rate of return, also known as bond yield. Periodic interest rate payments are also called coupon interest.
Bond prices are inversely related to bond yields. Bond prices rise and bond yields fall, and vice versa. Here is a simple chart to help you remember:
Wait a minute… what does this have to do with foreign exchange markets?
Always keep in mind that the relationship between the markets governs the price behavior of currencies.
In this case, the bond yield can actually be used as an excellent indicator to judge the stock market situation. The US Treasury yield is a measure of the performance of the US stock market, which in turn reflects the size of the demand for the US dollar.
Let’s look at a scenario: when investors are concerned about the security of stock investment, the demand for bonds usually rises. The behavior of fleeing to safe assets caused the bond price to rise, and the bond yield fell due to the inverse relationship.
As more and more investors move away from stocks and other high-risk assets, the demand for lower-risk financial instruments, such as US Treasury bonds and safe haven dollars, has increased their prices.
Another reason to pay attention to government bond yields is because they are the indicators of interest rates and interest rate expectations in the country.
For example, in the United States, you should pay attention to 10-year Treasury bonds. The dollar is bullish when its yield rises, and the dollar is bearish when its yield falls.
It is important to know the underlying drivers of bond yield rises and falls. It may be based on interest rate expectations, or market turmoil, or for security reasons, to escape from low-risk bonds.
After understanding why rising bond interest rates cause a country’s currency to appreciate, you may be eager to understand how to apply it in foreign exchange transactions. Be patient, novice.
Think about our purpose of conducting foreign exchange transactions (other than obtaining income). Our purpose is to combine a strong currency and a weak currency by comparing economic conditions. How can we compare bond yields?