Using yield curves as a guide to FX rates

FX Strategy Articles > Fundamental articles

In a previous article we looked at how interest rates affect fx rates. If you are not familiar with this concept, you should first review that article before reading on. This article looks at how the yield curve can be used to predict future interest rate trends.

What is a yield curve?

Each country has a separate yield curve that is derived by looking at the yield/interest rate of government bonds that are identical except for their maturity date. For example, some government bonds have a 3 month maturity date and some have a 30 year maturity date and they all pay different rates.

Take the example shown in the table below which are actual U.S bond rates for bonds of differing maturity taken on the 11th of April 2011. As you can see by the chart the 30 year bond is yielding 4.48% while the 1 month bond is yielding 0.03%.

From such data a yield curve can be constructed as shown in the chart below. The yield curve can be thought of as the combined expectation of market participants as to the direction of interest rates over time. For example, interest rates are expected to stay low in the US for at least the next 5 years as the US covers from recession, the global financial crisis and a crippling foreign debt.

How can the yield curve be used in to predict FX rates?

As you know, foreign exchange is traded in currency pairs so looking at one countries yield curve in isolation is not particularly useful. What is informative is comparing the slope of two countries yield curve as a guide to how the interest rate differential might change over time. Remember, interest rate differentials effect exchange rates as investors tend to prefer holding currencies that provide higher interest rates than those that provide lower interest rates. It’s important to look at the slope and not the absolute value of the rates as the market has already factored in the current interest rate differential in the current FX rate for the AUD/USD.

As you can see, for the next year the slope of the Australian yield curve is much steeper than the U.S one. What we would expect to find is a continue appreciation of the AUD/USD because of this. As the U.S economy beings to recover in years 2 and 3, the slope of the US yield curve becomes much steeper than that of the Australian one. This will cause a deprecation of the AUD/USD as the US economy picks up and money flows back into the greenback as interest rates in that country pick up.

Yield curves are updated every day and provide the best fundamental guide on how a cross currency pair may move in the short to medium term.

Published on 13th of April 2011
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