Header Ads

  • Ticker News

    How To Understand Quickly Bonds Role As A Market’s Vigilantes !

    When markets experience anxiety about conditions, money seeks safer assets. Government Bonds fulfill the role of providing a relatively safe place for capital. Bond markets are often overlooked by forex traders because of the mind-set that currency price charts are sufficient to understand and predict direction. However, a great deal of insight into market expectations on currencies can be gained by following bond markets. 

    The bond market is known to provide a gauge of macro attitudes on the risk environment regarding a country, known as “bond vigilantes.” Consider the fact that the 10-year US bond yield on September 30, 1981 reached 15.8%. A clear warning of a very risk-off environment was developing. On December 22, 2017, as the year ended the yield on the 10-year bond reached a 2.54%. Traders will note that when the 10-year US note yield probes or surpasses 3%, a great deal of attention will be generated on the Bond market as a potential omen of the beginnings of a risk-off market.

    It is also particularly relevant to measure the yields and perceived relative risk of the 10-year bond of different countries. For example, the 10-year government bond of Germany offers a much lower yield than the 10-year government bond of Spain. It is because the markets require higher yields to compensate for the greater perceived risk of Spain. 

    Underscoring the importance that bond patterns are harbingers of economic changes, the Financial Times, December 11, 2017 reviewed the China markets and led with a headline: “China volatility clouds Investment Outlook. Sell-off prompts fears of impending slowdown as government bond yields jumped.” Evidently, the Bond Vigilantes are a global phenomenon !

    Interest ratesYield
    US Government 10-year2.43
    UK Government 10-year1.23
    YGerman Government 10-year0.43
    Japan Government 10-year0.05
    US Government 30-year2.76
    Source: Financial Times

    The trader should look carefully as to whether the US 10-year bond yield is increasing compared to other countries. 

    This is important because capital will tend to flow to the US dollar and strengthen it as a place of greater return. An easy source for finding the different yields among key countries is the Financial Times (Table). In scanning the comparative yields, we can see a striking difference between the 10-year US Treasury yield of 2.49% and the Japanese Government 10-year yield of 0.05%. In this observation, the question arises of why the Japanese 10-year yield remains close to 0%? The forex trader should know the answer. The short answer is that the Bank of Japan was forcing the 10-year note to be zero to encourage spending as part of its stimulation policy called QQE (Quantitative and Qualitative Easing).

    Bond Market Shows Inflation Expectations

    A quick check on whether inflation expectations are increasing can be gained by looking at an Exchange Traded Fund (ETF) that tracks these expectations as expressed in the bond market. ProShares Inflation Expectations ETF (Symbol Rinf.k) (Chart 2.7). The chart indicates the upward direction of the share price of this ETF. By the end of 2017, inflation expectations were clearly going up and in sync with Federal Reserve projections. Let us take a closer look at how inflation expectations are generated.


    TIPS are a key factor in the inflation expectation equation. Here is what the US Treasury says about TIPS:

    Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS are issued in terms of 5, 10, and 30 years.

    The key idea behind tracking inflation expectations is to understand that a Treasury Yield is composed of the TIPS yield + Expected Inflation. So by tracking the difference between the TIPS and the Treasury Yield we are able to track inflation expectations (Table). If the spreads narrow towards 0 and in fact became negative, we have conditions known as a flattening yield curve.

    The US dollar index
    10-year vs 2-year yield58.6
    30-year vs 5-year yield58.1
    Source: Thompson Reuters

    As mentioned earlier, the forex trader does not have to worry about what to follow, the ETF does the job for us. Still, let us be sure that one understands why this is important to the forex trader? The reason is that a rising expectation in inflation will create bullish pressures on the US dollar and vice versa. There are similar ETFs that track inflation expectations for other countries.

    Flattening and Inverse Yield Curve

    Let us look at the famous concept of the flattening yield curve. It is very well known as a leading indicator of a slowdown in the economy. This is when the difference between a 10-year and 2-year Treasury yield is narrowing (or the 30-year and 5-year curve (Table 2.3)). The short-term yield rises when the central bank seeks to raise rates. But the longer-term yield does not go up if expectations of longer-term inflation and less long-term growth are also occurring.

    On December 24, 2017, these two comparisons were calculated by Reuters:

    Here is what the president of the Minneapolis Federal Reserve described in relation to the yield curve at the end of 2017:

    I believe the FOMC’s rate increases are directly affecting the yield curve: As the FOMC has raised rates, the front end of the curve is moving up with our policy moves, which is to be expected. But because the Committee has been raising rates in a low inflation environment, we are sending a hawkish signal, which is likely holding down the long end of the curve by depressing inflation expectations. 

    An inverted yield curve, where short rates are above long rates, is one of the best signals we have of elevated recession risk and has preceded every single recession in the past 50 years. A very useful further explanation of the concept behind an inverted yield curve can be found in the following New York Times article: What’s the Yield Curve? ‘A Powerful Signal of Recessions’ Has Wall Street’s Attention By Matt Phillips June 25, 2018.

    The Commodity Complex; Crude and Copper

    Crude oil reflects longer-term optimism or pessimism regarding global growth. Although there has been an emergence of “green” technologies, the world still runs on crude oil. Crude oil prices at the end of 2017 began to probe the $60s far from the deep lows at $25 of Jan 2016. Keep in mind the that oil in the $60 (as of April 2018 (see the circle in Chart ) is far from the $140 price in July 2018 (Chart). A sharp increase in crude oil is often in response to geopolitical crises or supply disruptions. Crude price is often a gauge of expectations regarding OPEC’s (Organization of the Petroleum Exporting Countries) capabilities of limiting production. The fracking technology revolution has greatly limited OPEC’s ability to limit supplies. The effect is more of a range of behavior in oil.

    Crude oil on the rise

    Because Canada is a net exporter of Tar Sands Oil, the Canadian dollar is impacted by crude oil news. If oil prices are increasing, the demand for Canadian dollars will increase and this is a bullish condition. The forex trader should be aware of oil supply data releases and check it on their economic calendar.

    Dow Jones Commodity Price Index

    Do not forget copper. Copper is the industrial infrastructure metal that a growing economy requires. It is logical, therefore, that the demand for copper will reflect the expectations of global economic conditions and, in particular, China’s growth expectations. Since Australia is a major exporter of copper, the Australian currency is the one to watch for changes in the global demand of copper.

    One does not have to search far and wide to get a sense of the commodity markets. The Dow Jones Commodity Price Index is a useful overall gauge of the commodity complex including oil. We can see that the commodity complex has been in a bullish upsurge. If a sell-off occurs in this gauge, traders would see the weakness in commodity currencies such as the CAD, Australian, and New Zealand dollar.

    Traders should keep in mind that there are actually a variety of Dow Jones Indexes and they can be accessed at:

    Understanding which fundamental forces are in play provides the trader with a global and macro view of the markets. While there are a huge number of fundamental factors, those listed in this chapter provide a starting point for the forex trader and a foundational step towards trading with the fundamentals in mind. The challenge ahead is to translate the macro view into the micro view.

    No comments

    Post Bottom Ad

    Powered by Blogger.