Getting the information

As we know, speculative FX trading has far bigger volumes than real deal flow (actual transactions conducted in private between investors and their banks), but second-guessing potential real deal flow makes up a big part of speculative trading.

It’s easy enough to get U.S. 10-year T-note yield data (from the Federal Reserve databank) and overlay it with the euro/U.S. dollar exchange rate. The correlation looks pretty good. As the yield on the 10-year bond was falling, the euro was rising, albeit with quite a lag. But this is only one-third of the story. We also must consider what the yield is doing in the equivalent German 10-year bond (conveniently named the Bund), and we also have totake into consideration the yield shown is the nominal yield, not the real yield. Additionally, it’s not easy to get the German Bund yield. Yields are published every day by financial newspapers such as the Financial Times, but it’s impossible to get the historical data set unless you collect it yourself or pay a data vendor.

Professional FX trader shave charts of 10-year note pairs on terminals as a matter of course. In fact, they set up such charts to show only the yield differentials, and overlay the relevant currency pairs. This is illustrated which shows the U.S. 10-year Tnote/ German Bund yield differential
along with the euro/U.S. dollar rate (courtesy of currency trader Bob Sinche at Bank of America).

The chart shows a daily time frame, but in practice you could display the information in hourly bars, 15-minute bars or any other configuration. Bond traders respond to the same information we watch in the FX market — payrolls, business and consumer confidence surveys, inflation rates, etc., in both countries — and their collective judgment of fresh data is reflected on the chart.

On this chart, the euro (solid line) fell from a peak in February to lows in April and May as the differential (dotted line) went over -.40 points against the euro (right scale). Then the yield differential against the euro started to move back toward zero into September, while the euro was mostly in an uptrend.

In September, there was a curious divergence in which the euro fell while the yield differential was still shrinking. That’s a divergence that doesn’t make sense. There should not be a bias against a currency (the euro) when its return is getting closer to the return on its competitor, the dollar. Hence, if you were watching this chart, you could have predicted the euro was being oversold and was going to rise, as it
subsequently did. The euro broke upside resistance around 1.2420 on Oct. 15 and soared over 1.2800 by Oct. 26 (see chart inset), an unusually sharp breakout.