What Is a Bond Spread?
A bond spread is the difference between the bond yields of two countries.
This difference plays a key role in the carry trade, which we covered in a previous lesson.
How Bond Spreads Influence Currency Exchange Rates
By tracking bond spreads and expected interest rate changes, you can get a sense of where currency pairs might be headed.
Here’s how it works:
When the bond spread between two countries widens, the currency of the country with the higher bond yield tends to strengthen against the currency of the country with the lower bond yield.
Real-World Example: AUD/USD and Bond Spreads
Look at the bond spread between Australian and U.S. 10-year government bonds from January 2000 to January 2012.
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Between 2002 and 2004, the bond spread grew from 0.50% to 1.00%. During that time, AUD/USD rose nearly 50%, moving from 0.5000 to 0.7000.
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In 2007, when the spread increased from 1.00% to 2.50%, AUD/USD climbed from 0.7000 to just above 0.9000—an impressive 2,000-pip gain!
Then came the 2008 recession. As major central banks cut interest rates, the bond spread tightened, and AUD/USD fell back from 0.9000 to 0.7000.
What’s Driving These Moves?
Traders often use carry trades to profit from these bond spread changes.
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When the bond spread between Australian bonds and U.S. Treasuries widened, traders bought AUD/USD to earn higher yields.
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But when the Reserve Bank of Australia cut rates and the bond spread narrowed, those carry trades became less attractive, so traders closed their long AUD/USD positions, causing the currency to weaken.
Another Example: GBP/USD and US-UK Bond Spread
Similarly, when the bond spread between UK and U.S. bonds narrowed, GBP/USD weakened.