In the last part of my series on intermarket analysis I covered the relationship between Forex and equities, a market that is familiar to most people. In this part I will discuss the bond market, a market that is not familiar to most people.
One of the main reasons people avoid bonds is because they do not understand what they are or how they are priced. Bonds are simply loans granted to governments, and are easily understood if they are purchased direct from the government. It is in the secondary markets, however that they begin to get confusing.
There are two ways to value a bond in the secondary market: price and yield. Yield is the more common of the two. A bond’s yield represents how much you would earn if you kept the bond until it matured. Since you do not pay the same for a bond in the secondary markets this value is not the same as the original yield. If you pay more than the original price the yield will be less, but if you pay less for the bond the yield will be more. It is because of this fact that yield and price always move opposite of each other. The price is represented as percentages of the bonds face value in $1000. So, for example if a bond was priced at 98:00 you would pay $980 for each $1000 of face value you wanted.
In relation to the Forex market, the bond market is a thermometer of risk aversion. As opposed to the equity market, bonds are seen as a safe asset with limited room for growth. So, when investors are afraid and risk averse they tend to buy more bonds, so the price rises and their yield falls.
Bonds are also more closely tied to their local currencies than the local equity markets are. This is because bonds must be purchased with local currency and are used as tools of the central banks to help manipulate the money supply. The purchasing of bonds has two important effects on the currency. First, as bonds are purchased (replacing liquid assets with illiquid ones) the money supply falls, at the same time as more people want to buy bonds more of the local currency will be demanded. Money is just like any good, a fall in supply and an increase in demand results in an increase in price. Therefore, the demand and price of countries bonds can be used as a strong proxy for the international demand and price of its currency.
So, when a rapid increase in USD is seen at the same time as a decrease in bond yields (or an increase in bond price) then we know that the dollar strength is coming about by a flight to safety rather than an unwinding of trades.
