Why are Bonds And Currencies Correlated?

There exists a strong correlation between bonds and currencies. So, you must pay attention to this correlation. One of the reasons is the interest rates. For example, look at this chart. The purple line is the Australian 1-year government bond yield. The orange line indicates the Australian cash rate. As you can see from the chart, both are closely correlated.

When you increase the duration more than a year, then you need to understand the term premium, which means the additional return the investors expect for taking on a risk to hold the bond for a longer duration. As you can see from this chart, there still exists a strong correlation for the 10-year bonds.

A currency with high interest rates is preferred by investors.They use a strategy called carry trade. You basically a high interest rate currency against a low interest rate currency and you are paid the interest for holding it overnight. So, the higher the interest rate, the more the swap. So, the low interest rate currency is used as a funding currency and benefit from the interest rate differential.

When the demand for the bonds increases, then it also increases the demand for the currency involved. So, when the more Australian bonds are sought by the investors, it also increases the demand for the Australian dollar.

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