Forex Trading Library

Why You Should Care About Peripheral Yields

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In a Forex context, “peripheral yields” generally refers to the yields on bonds issued by countries in the EU “periphery”.

They were closely followed by traders around the 2011 financial crunch, and have since been somewhat forgotten.

However, they are still an important and useful tool for forex traders, especially those who trade the euro. Let’s take a closer look at how peripheral yields are related to currency moves.

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What Makes the Euro Special

Bond yields are directly related to the value of currencies. The differences in interest rates influence the prices and interest paid on bonds. This, in turn, drives demand for currencies. This is how a central bank can strengthen or weaken a currency by changing the interest rate, which affects the yield on government bonds.

The euro area is, however, a bit unique. This is because it’s a single currency (and monetary policy) that applies to several countries. And the creditworthiness of those different countries varies!

That is why each country in the eurozone has different bond yields. Bond traders shop around these countries to get the best return on their investment.

The Dividing Line

Countries considered more stable and able to pay off their debt, like Germany, have lower yields on their bonds. Countries that are more likely to default on their debt have to pay a premium to entice investors to give them their money. They have higher yields.

Stable countries are often called “central”, because they are in the center. And they are, basically, just Germany. Less stable countries (that is, the ones with high deficits and debts) are called “periphery” countries. The ones that matter for our purposes, though, are Spain and Italy (some analysts also include Portugal and/or Greece).

The Spread

The difference between the yield of Italian and Spanish bonds compared to German ones is called a “spread.” Basically, it’s how much more Italy and Spain have to pay in order to entice investors to take on a riskier position.

This is especially useful because unlike other yield spreads which can be driven by differences in monetary policy, all 3 countries use the same currency. And, they are subject to the same policy.

The spread with the periphery is a much better gauge of risk sentiment. If the spread increases, it means investors are shying away from risk. If the spread closes, then it means investors are interested in taking on more risk.

What it Implies for Currencies

When the market is feeling optimistic and there is a risk-on attitude, this weakens safe haven currencies and strengthens emerging markets. A widening spread in peripheral yields could be a sign that the market is in a risk-off attitude. This would support currencies like the dollar and the yen, at the expense of the lira or peso.

A widening spread can also mean that investors are worried about the stability of the euro. It would indicate that they are seeking to move their investments from the higher risk periphery to the lower risk center. This would translate into weakness in the euro.

No Gauge is Perfect

Bond yields change in real time. And the spread is a good guide of current risk sentiment. However, there are several individual issues that could affect countries. These include elections or other geopolitical concerns. This is why it’s always a good idea to keep track of the news when setting up your trades.

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