Forex RouteMap: Interest Rate & Bond Yield

 Buy when the green and yellow lines trend higher

Sample chart showing correlation between exchange rates and changes in comparative bond yields (green) or interest rate differentials. Forecast year on year changes shown in different colours.

This strategy shows the attractiveness of one currency relative to others for portfolio investors. It uses the premium or discount of real domestic interest rates over international levels. Where available, rates at both short three-month and long ten-year ends of the yield curve are shown. For comparability, exchange rates have been rebased to set year-end 1994 at 100.
 
The exchange rate is shown as the thick white line on the right hand axis. The two explanatory variables, short-term interest rates shown as the yellow line and long-term interest rate premiums shown as the light green line, use the left hand axis. Best Guesses as to the future development of the variables are also shown on the left hand axis. The Best Guess for interest rates is the thin orange line. The Best Guess for long-term rates is the light green line.
 
Best Guesses show what would happen to these premiums or discounts based on Consensus Forecasts for interest rates, bond yields and inflation both at home and abroad. Depending on whether the investment perspective is Dollar-based or relative to a global benchmark, the relevant foreign forecasts are those for the United States or a GDP-weighted global average. Forecasts are based on consensus estimates.
 
Owing to the conversion of legacy currencies into Euros, analysis is provided on the common currency, rather than for individual countries. Historical data is provided by creating synthetic GDP-weighted time-series for the component currencies, expressed in the European Currency Unit.
 
Past experience shows that exchange rates can be highly sensitive to small changes in relative attractiveness on this basis.