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Bonds And Currencies Correlated
A question from Noel who is asking for some insight on the correlation between bonds and currencies.
Now there’s two main reasons for bonds and currencies being closely correlated.
The first one is interest rates. And as we can see on the chart in front of us, we can see Australian one year government bonds yield in purple, and we can see the Australian cash rate. So the Australian base interest rate in orange. And as you can see, both of these are very highly correlated with one another.
The reason why we’re looking at the one year is because that really does simply reflect just the expected yield on a bond, on a bond which is of course, very closely correlated with interest rates. Now we can look at higher durations for bonds, but the further out you go, you add what’s called a term premium. And a term premium is simply the additional return expected by investors for taking on a risk of holding a bond for a longer period of time. And of course, that comes with additional risks such as the risk of default. But as we can see, even here, looking at a 10 year there is a very close correlation between the two.
Likewise, with a very close correlation between interest rates and yields on bonds, there’s a very strong correlation between interest rates and currencies. And a big reason for that is because of course on a currency you are paid a carry. So every time at market rollover, you receive a little bit of interest, which is the equivalent to holding that currency overnight. And now, for that reason, you have a lot of interest in a market strategy, known as carry trades, which is where you hold a high interest rate currency against a low interest rate currency, and effectively, you’re paid the interests of a swap of just simply holding that currency overnight.
For that reason, the higher the interest rate is, the more of a swap you’re going to receive on a currency and that makes that currency more attractive to hold. And likewise, for that reason, again, going back to swap trades, if you have a low interest rate on the currency, that currency is more attractive as a funding currency.
So, a currency you can look too short simply to in order to buy that higher yielding currency and then benefit from the interest rate differential between the two currencies.
Now, the second reason why there is a correlation between bonds and currencies is simply because of in order to buy a bond from another country, you firstly have to buy that foreign currency to buy that country’s bond.
Say for example if a Australian bond has a higher yield than a domestic bond or a bond in your own country, then Australian bonds are going to appeal to you more than domestic bonds are because they return a higher yield.
So for that reason, what you’re going to have to do is you’re gonna have to buy Australian bonds by firstly buying Australian currency, which means selling your own currency, buying Australian currency, and then using that to purchase bonds.
So for that reason, if bonds in Australia, in this example are more attractive, then there’s also going to be increased demand for Australian dollars because investors are gonna have to buy Australian dollars before they can buy Australian bonds.