If you are serious about trading Forex then you have to follow the 10-year Treasury yield chart. It is one of the most important correlations in the foreign exchange market.
More than 80% of all currency transactions involve the U.S. dollar so on most days, the market’s appetite for U.S. dollars determines how other major currencies trade.
For example, if the market is very bullish dollars, chances are the euro and sterling will be trading lower (barring any country specific concerns that day).
In fact, the following chart shows just how strong the correlation between the 10-year yield and the dollar index has been for the past 2 years.
This same uncannily tight correlation can also be seen between the 10 year yield and the U.S. dollar / Japanese Yen currency pair.
Any investor can attest that interest rates are an integral part of investment decisions and can drive markets in one direction or another.
The Federal Reserve’s monetary policy decision is one of the most market moving event risks on the calendar, rivaled only by the U.S. non-farm payrolls report.
What the Federal Reserve says or does impacts bonds, currencies and equities. That’s why experienced Forex traders will always have one eye on bonds and the other on the U.S. dollar because the move in the greenback often coincides with the move in yields.
So the question becomes which one is the leading and which one is the lagging indicator. In other words, do currency pair prices predict interest rate movements, or do interest rate movements drive currency prices?
The answer is of course tricky – whether interest rate differentials are a leading, coincident, or lagging indicator of currency prices depends on how much traders care about future rates versus current rates.
Assuming efficient markets, if currency traders only care about current interest rates and not about future rates, one would expect a coincident relationship. If currency traders consider both current and future rates, one would expect interest rate differentials to be a leading indicator of currency prices.
Sounds confusing? Don’t worry.
The rule of thumb is that when there is a big move in the yield spread, it will coincide with a big move in the currency pair and if that hasn’t happen, then it signals an imminent move in the pair, providing you with a trading opportunity.
Now no correlation is perfect. There will be times when interest rate differentials matter more than others and that tends to be when central banks are at the cusp of or engaging in major monetary policy changes.
To trade Forex well, it is important to look beyond the 10 year Treasury spread and the dollar because what’s really important are the differentials in interest rates.
In FX trading, an interest rate differential is the difference between the interest rate of a base currency (appearing first in the pair) less the interest rate of the quoted currency (appearing second in the pair).
Understanding the correlation between interest rate differentials and currency pairs can be very useful particularly since it is the single most important driver of currency movements.
In addition to monetary policy decisions, the future direction of rates along with the expected timing of rate changes is also critical to currency pair movements because money moves from one part of the world to another in seek of the highest yields. So for a pair like the euro – U.S. dollar (EUR/USD), keep an eye on how German bund yields are moving relative to U.S. Treasury yields.
Until next time,
Ms. Kathy Lien is the Managing Director and Founding Partner of BKForex’s strategies and creator of the new course The ULTIMATE Forex Trading Course produced in conjunction with Weiss Educational Services.Kathy, a leading currency and Forex expert, started the #1 Forex news site DailyFX.com, is a regular contributor to CNBC Squawk Box and is a former host of CNBC’s Forex show, Money in Motion. She is also an internationally-published author of the best-selling book, “Day Trading and Swing Trading the Currency Market” (now in its third edition) and “The Little Book of Currency Trading.”