Bond Yields affect the Forex market indirectly because they influence interest rates.
When the bond yields fall, it shows a slow down in the economy hence low currency value.
This prompts the Central bank to increase interest rates. High interest rates mean currency appreciation.
How Bond Yields affect forex market
Bond yield is the rate of return an investor realizes from a bond after the maturity period.
Conversely, bond price is the amount the bond currently costs on the secondary market.
Bond yields affect forex by determining interest rates. It is the interest rates that move bond prices
When the bank interest rate is lower than the bond interest, bond prices increase because the bond gives better return.
Lower interest rates means loans are cheap and so is spending.
This boosts economic growth but the increase in bond prices lead to fall in bond yield.
Low interest rates Increases bond prices which leads to low bond yields. Low bond yields indicate low currency value
If the central bank wants to increase the interest rates, it sells off the bond to investors at a lower price to reduce money in the economy.
Therefore higher interest rates means lower bond prices. And so the bond yield will also rise.
A fall in bond prices increases interest rates and currency value.
Bond yield versus bond price
Bond yield moves inversely with the bond price.
When the bond prices increase, the bond yield falls. And this also shows that, as the demand for the bonds increase, the yield falls too.
When demand for bonds increase on the secondary market, prices also rise. However the interest payment for the bond holder stays the same.
This is because, interest payment for the bonds is set when the bond is first sold. It stays fixed no matter how many times the same bond sold or bought.
When you buy a bond on the secondary market, you receive the the same amount of interest even if the price is higher than its face value.
Therefore, the cost becomes higher than the yield return
Bond Yield Versus the stock market.
Bond yield serves as the best indicator of the strength of a nation’s stock market as well as the country’s currency.
This is because most investors usually demand bonds when the stock market becomes riskier.
When the bond yield falls, it shows a slow down in the economy.
As a result, investors will turn their fortune into bonds liquidating their shares in the stock market. They are willing to accept lower yields just to keep their money safe.
This is an indication for a collapsing economy and less demand for the local currency hence value devaluation.
But, if the bond yield rises, it means the economy doing well as well as the stock market.
Nevertheless, investors rather invest in stock markets than buying bonds.
Those who issue their bonds can only afford to pay a small interest however the secondary market prices bonds beyond their face values.
This makes interest payment lower than the price paid hence lower return and yield.
Bonds are more attractive when the economy and the stock market declines. Reason? Bonds return a fixed interest payment.
As more investors get to the stock market, demand for local currency increases hence currency value appreciation.
How do bonds work
If you want to invest in the bond market, you can either buy and hold the bonds or trade bonds.
In case you choose to buy a bond,
The borrowing organisation promises to pay the bond face value back at an agreed date.
Until then, you simply receive the agreed interest payments from the borrower till the bond matures.
At maturity date of the bond, the debtor/borrower pays back the principal/ the initial money you lent out for the bond.
Alternatively, you can choose to resell the bond before it matures; Bond trading. This can only be done on the secondary market for bonds.
Bonds are either publicly traded on exchanges or sold privately between a broker and a creditor. When this happens, the prices of the bonds will fluctuate till its maturity.
However, this is not the case as when you choose to hold the bond till maturity. Your interest payments and bond face value won’t change at all.
Types of bonds
The different types of bonds vary according to who issues them, length of maturity, interest rates and risk involved. They are;
Treasury Bills
These have a maturity of one year or less and have the least interest rate.
Treasury Notes; Their maturity is between 2-10 years,
Treasury bonds; More than 10 years. Unlike most bonds, Treasury inflation(TIPS) protects you against inflation.
Government Agency Bonds.
These are the housing related agencies such as the Government National Mortgage Association(GNMA).
They are issued by the Government- sponsored enterprises or a federal agency.
Municipal Bonds;
These are issued by cities, state and other municipalities.
The Corporate Bonds
They are issued by companies and corporations.
They are riskier than the government bonds and have higher interest rates.
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