EUR/USD Fundamentals (part 1: Treasury-Bund yield spread)

The EUR/USD is the most traded currency pair in the forex market, and the most liquid asset in the world - so it pays to understand its fundamentals.

To really have a comprehensive view on how to trade the EUR/USD, you need to have a solid grasp of the fundamentals which underpin the volatility in the exchange rate.

Economic data from the Eurozone impacts the EUR/USD as well as the other euro currency crosses (EUR/GBP, EUR/JPY etc). Much of the economic data from the Eurozone is not market-moving and ought to be ignored. We need only to study those economic reports that have the potential to drive volatility higher and those that can promote trend development.


European Economic Releases

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Economic data helps economists to forecast monetary policy. The European Central Bank (ECB) is responsible for establishing the monetary policy of the euro currency area. Subsequently, the ECB’s monetary policy is the main driver for the euro exchange rate and has a long-lasting effect on price trend development.

Monetary policy is decided on the basis of this economic data, therefore gauging fundamental data can help traders forecast possible changes to monetary policy and subsequently the short-term and long-term EUR/USD trends.

Investors hold a currency in order to earn a return via an interest rate that is higher than might be earned in other currencies. The equivalent to this in the stock market is owning a stock to earn the dividend. The inherent return on owning a bond is the interest assigned on the coupon.


In Summary, the interest rate determines the demand for the asset in hand - and in the case of currencies, we will watch anything that affects future changes to interest rates by central banks.


Bund – Treasury Yield Spread

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The spread between US 10-year Treasury yields and German 10-year bund yields is an important factor that governs how the EUR/USD exchange rate moves. Bond yields are a real-world example of what investors can earn on ‘risk-free’ assets in a given currency.


The comparison of the two bond yields i.e. the spread tells us which currency yields more interest and how that difference is changing over time.

The Bund - Treasury yield spread is simply the difference between the USA and Germany’s bond yield. The theory goes that the currency with the higher yield will be worth more than the currency with the lower yield. If expectations in the market are for interest rates in Europe to rise faster than the United States, the euro should rise relative to the dollar.

In other words, when the Bund - Treasury yield spread is rising the EUR/USD exchange rate should also be rising. Conversely, when the Bund - Treasury yield spread is falling the EUR/USD exchange rate should decrease.

Movements in the Treasury-bund yield spread can be used to forecast the EUR/USD exchange rate. Although factors like the need for liquidity or the avoidance of political risk can effect the short term movements in a currency, over time investors will always chase the higher yielding currency over a lower yielding currency to take advantage of the carry.

A divergence between the bond yield spread and the EUR/USD exchange rate can sometimes give you a clue there is a bottom or top coming the exchange rate. For example, if the EUR/USD exchange rate is rising, but the bond yield spread is not, in theory traders should be preparing to go short EUR/USD.

A complete fundamental analysis of the EUR/USD currency pair will also need to include looking at the other side of the monetary policy spectrum, aka the US economic data releases that drive the greenback.


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