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Bond Yields & Equities
Just quickly following up on a question from a viewer asking us what the relationship is between bond yields and equities and how they affect currencies.
Now, the most important thing to realize first of all is that correlations are never perfect. So even though we usually see bond yields and equities impact currencies in a particular way, that doesn’t mean that it will always happen the exact same way every time, all the time.
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Now, when it comes to equities, the most useful and observable impact on a day to day on currencies is due to risk turns. So whenever we see significant downside or upside in equities across the board, so that’ll include Asia-Pac equities, European equities, new, American equities, that can usually serve as a very good gauge of the overall market sentiment, the overall mood in the market.
So when we see equity markets are tanking across the board, that is usually a sign of a possible risk off environment and when we see equities rising across the board, that is usually a sign of a risk on environment.
Now, it is important to note that it’s not perfect and can sometimes move the opposite to currencies despite seemingly strong sentiment in the market, which might be driven by individual factors at the time, maybe by earnings, releases, etc.
Then looking at bond yields, bond yields can also be a useful gauge off risk sentiment, especially US Treasuries. US Treasuries are considered as one of the safest investments money can buy, which usually means that during times of intense market turmoil, we usually see bond prices rise and, or, bond prices rise and as bond yields fall, and vice versa when things, when we see a very strong risk on appetite in the market.
Now, it’s also important to note that bond yields don’t only move based on risk turns, its actual main bigger primary driver is actually based on interest rate changes, and more importantly, interest rate expectations. And a very good example of this is by taking a quick like, a quick look at this chart, this line in the blue, which is basically the US government 10 year yield.
Now we can see from the start or from the end of 2018, that US government yields was moving lower sharply and that was based on the market starting to price in lower interest rates for the US economy as the economic cycle was starting to slow.
Now, generally speaking, a currency would usually follow its bond yields as both currencies and bond yields move in line with interest rate expectations.
So when we see these expectations for interest rates to go down, we would expect the currency to go down as well. But just like all correlations, this isn’t always perfect and we can see that example here on the chart where the orange line is actually the dollar index overlaid with this US 10 year.
Now we can see that the US dollar didn’t fall alongside interest rate expectations, as the dollar was still favored among its peers throughout 2018 and 2019 as the US economy was still doing far better compared to most of the other major economies. So the dollar with its much higher interest rate at the time, and stronger economy at that time still outperformed most of these other current currencies despite the fact that the US 10 year yields was actually moving lower.
So it’s a good indication to use, it’s nice to use bond yields as well as equities as part of our analysis, but we do need to remember that the correlation’s on perfect and they can sometimes have dislocations in the market where we see them diverge, and at those stages, it’s very important to understand why they’re diverging and how we can take advantage of that in our trading.