Using Bonds as an FX Indicator (Part 2)

04/16/2012 11:55 am EST

Focus: FOREX

James Stanley

Trading Instructor, DailyFX Education

James B. Stanley of DailyFX.com continues this multi-part article series about how the Treasury bond market provides helpful clues to currency traders.

In our last article, (read Part 1 here), we looked at the history of US Treasuries and how US Treasury instruments began to be considered one of the “safest investments in the world.”

In today’s article, we’re going to get more in depth with the structure of these important assets, how they are traded, and even more importantly, we’re going to lead in to how forex traders can use Treasuries to glean directional biases in the markets, assisting with everything from short-term scalping to long-term position trading.

The Structure of Treasuries

There are quite a few different flavors of US Treasuries. The Treasury bill, dubbed the “T-bill,” is the shortest-term variety, often issued at 90 days, but the term ‘T-bill’ pertains to all Treasury debt issues of less than one year. Due to this short-term maturity and the fact that the United States government has never defaulted on a dollar of debt, this is often considered the “risk-free” rate of return.

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Treasury notes are debentures with maturity between one and ten years, and Treasury bonds have maturities longer than ten years. Due to the fact that these bonds have longer maturities, the risk is seen as being slightly higher. Thus, the interest rate will often increase the longer the maturity is set out in the future.

So as a generality, the longer the maturity, the higher the rate. This forms the yield curve, which will be covered in the next installment to this article series.

Each week, the Treasury Department holds public auctions for new debt. The maturities that are being sold will differ, but the bill will be one of the issues sold at each auction, as this is sold to cover short-term expenses.

The Pricing of Treasuries

The first thing that traders need to learn about Treasury bonds (and most bonds, for that matter) is that price and yield move inversely. If investors are bearish and sell bonds, we will see yields increasing. This can happen for a number of reasons: Perhaps investors would rather invest in stocks to look for a higher return; or maybe the credit quality of the issuer has come into question and traders look for other bonds (with fewer questions on the issuer’s ability to pay interest).

Treasury bills are always sold as a “zero-coupon” bond, which means simply that the bond is sold at a value of less than par, commonly $1,000 per unit, and when the maturity comes due, the investor gets the full $1,000 to compensate for the initial purchase price, as well as the interest owed.

For example, if I buy a six-month Treasury bill at 97 today, that would mean I paid 97% of the par value of the bond, which would mature at $1,000 in six months. So I paid $970 today, and will receive $1,000 in 6 months, for a return of $30, or 3%. But this was only for six months, so I would be looking at an annualized rate of return of 6%, assuming no compounding.

Sound confusing? Don’t worry, this is confusing to almost every new bond trader or investor. When this begins to make sense is when we see how traders around the world price these important bond issues, regardless of how long they have until maturity.

Notes and bonds differ from the issuance of bills, as both will generally carry a coupon (rate of interest on the par value of $1,000 per bond) based on prevailing market interest rates. The Treasury will then announce the coupons ahead of the auction, and investors can decide how much they are willing to pay for the bond.

If the Treasury is paying higher-than-normal rates, investors will usually bid these bonds higher, meaning they will drive the price over par, at, say, 101 or 102.

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After the initial auction, Treasuries are traded in one of the most active secondary markets in the world, with investors around the globe buying and selling Treasuries for speculation, investment, and safe keeping.

NEXT: The Secondary Market for US Treasuries

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The Secondary Market

The secondary market for Treasuries is where the rates for all of the above issues are decided.

If the US reports surprising or disappointing economic numbers, investors around the world will often panic to some degree, and the degree of which will often be determined by the magnitude of the surprise.

If positive news is announced, investors fear missing out on a bigger return in markets such as stocks, so they sell their low-yielding Treasuries to use their capital in search of bigger returns elsewhere.

How This Affects the FX Trader

If an investor is buying Treasuries, what currency do you think they need in order to buy them?

That’s right, US dollars, and this is precisely the reason that traders in the FX farket may see massive strength in USD during a “risk-off” campaign.

See related: Risk-on vs. Risk-off Trading

Investors fearing for the safety of their capital will often think, “What good is a return on my principal if I’m losing my principal faster than I’m accruing interest?” If you are in an investment that is earning 10%, but you lose 15% on the capital, what was the point in the bigger return in the first place?

You are exactly right: there is no point. And this is exactly why investors will flock to safety during times of bearishness in markets. This can also be called a “safe-haven run,” as investors are running towards the safe haven that is the US dollar.

See also: 2 “Safe Havens” That Aren’t So Safe

The following table walks through the effect of risk on or risk-off for traders in the FX market:

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And, for an investor looking for safety, few assets on the face of the Earth can offer what United States Treasuries and the United States dollar can present to investors and traders around the world.

For more information on why the US dollar, and further, US Treasuries, are the safest assets in the world, our previous article on the history of US debt will offer more information.

In our next installment, we will look at various ways that traders can use interest-rate changes and Treasuries to denominate their strategy in the forex market.

By James B. Stanley of DailyFX.com

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