Trading the Forex with Bonds - Part 2

07/30/2008 12:00 am EST

Focus: FOREX

John Jagerson

Co-Founder and Contributor,

Bond prices are affected by several factors but some of the most powerful are investor tolerance for risk and inflation. This is helpful information for us forex traders that have to deal with the same issues as we look for new opportunities or exits in the market.

The reason bond prices are affected by risk tolerance is because they are considered "safe" investments. Therefore if the stock market looks weak, traders will seek yields in safer assets like the 10-year note. We all know what happens when demand for a particular investment rises - the price of that investment will also rise. Therefore, if demand for the 10-year note is rising as capital exits riskier asset classes like stocks then the price of those bonds will also rise. When you put this together it means that the yield on those notes will drop because the price of the note itself is not discounted as much.

But what does all of that have to do with forex traders? We can ask ourselves what currencies are likely to react to the fact that investors are seeking less risk assets? In today's market that may mean that the JPY will appreciate in value as traders sell USD and buy JPY to cover short JPY positions. Lower yields in the US can also push the value of the CHF against the USD so selling the USD/CHF currency pair may be a good bet.

The bottom line is that traders will perceive falling yields in the 10-year note as an indication that investors are becoming more risk averse. When that happens you should look for those currencies that are likely to move as capital shifts. Right now that may make the CHF and JPY two good long positions.

In the concluding section to this lesson we will look at actual techniques for timing trades using the 10-year note and will expand on some of the other bond indexes available.

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