Forex vs. Yield Spreads

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.

Now you just need
to compare it with the EUR/USD price chart to see the relationship and you will
notice that the yield spread generally leads the price of EUR/USD.

On the chart below, you will see that 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 eventually the exchange rate generally follows the spread.

For example, the last divergence was caused by the aggressive Fed tightening in 2022 while the ECB enacted a much slower strategy. Moreover, the war between Russia and Ukraine weighed on the sentiment and increased the pressure on the Euro. The pair eventually bottomed once the market sensed the peak in the Fed’s hawkishness.

I personally prefer to use the spread between the 10y yields, but in this case, the spread between the 2y yields (which is more sensitive to monetary policy) would have given a better picture.

Don’t trade just
based on the charts and correlations though but look for reasons and keep yourself
informed on the latest developments to give you a better edge. When you start to see a
divergence, be prepared to strike as soon
as the picture changes.