Yield is how much you’ve earned or can expect to earn from an investment over a specific period of time. The figure is expressed as a percentage of one of the following:
- The amount you originally invested
- Your investment’s current market value
Imagine you bought shares in a company for £100.
Over the next year, the company does very well. So well, in fact, that your shares are now worth £150.
The company also decides to issue a dividend — a share of its profits. Your dividend is £75.
This means you’ve made a profit of £125: an impressive 125% yield.
Speculators often maximise yield by using a strategy called a carry trade. This involves taking a low-interest loan in one currency, and using the money to make a high-interest investment in another currency.
The yield is the profit you make from the investment after settling the debt. So if, for instance, you borrow £3,000 at 2% interest and convert it into $4,000 which you invest in bonds yielding 6% a year, your yield is 4%.
A carry trade can increase your yield by orders of magnitude. The flipside is that, if the currency you borrowed in increases in value or the currency you invested in decreases in value, your losses can be equally large.
Using bond yields to make forex trading decisions
Forex speculators often look at the yield on bonds to help them make trading decisions. This is because interest rates are one of the factors that affect whether a currency will go up or down in value.
Let’s say you wanted to speculate on GBP/USD but weren’t sure which position to take. Should you bet on the British Pound going up in value? Or do you put your money on the Dollar?
Looking at bond yields can help you arrive at a decision.
First, you’d plot the interest rates available on the US bond market onto a graph called a yield curve. You’d also do the same with the British Pound.
The yield curves will give you an idea of where the bond markets think the US and British economies are headed.
If a country’s yield curve is inverted, that is, short-term bonds have higher interest rates than long-term bonds, it’s likely that the economy is headed towards recession. And the currency of a country that is suffering from a recession typically goes down in value.
By contrast, if the yield curve is sloping upwards, the country’s currency may appreciate in value (though upward curves can also be a sign of inflation, which means a currency’s purchasing power is decreasing).
A yield curve could also be flat or humped.
A flat yield curve means things are going to stay the same for a while. So if the economy is suffering from inflation, this is likely to continue. Similarly, if an economy is in recession and the yield curve is flat, this means the recession will likely continue for the foreseeable future.
A humped yield curve, on the other hand, is a sign that a country is headed towards a period of uncertainty or volatility.
- Yield is one of two ways you can earn money from an investment. The other way is by closing a trading position. You close a trading position either by selling your investment or by opening an identical but opposite position. So, if you have a put option — an option to sell — for instance, you’d buy a call option (an option to buy) with identical terms. The idea is that the two positions will cancel each other out.
- The most frequently reported yield curve compares three-month, two-year, five-year, 10-year, and 30-year US Treasury bonds. This curve is a benchmark not just for forex traders, but also for other debt like mortgage interest rates.
- Most yield curves tend to slope upwards. This is because interest rates on short-term bonds are usually lower than interest rates on long-term bonds.
Want to know more?
- Interpreting yield curves is part science, part art. This video explains the correlation between the bond markets and forex movements in detail, and shows you how to use yield curves to make better forex trading decisions.
- What’s the relationship between interest rates and the forex markets? This article explains it thoroughly in plain language.
‘Many investors tend to see high yield as a sign that an investment is a low-risk way to get outsize returns. But high yield isn’t always a good sign. Sometimes, it can mean that trouble is brewing — for example because a company continues to pay high dividends even though its profits haven’t increased.
For this reason, it’s important not to look at yield in isolation when you’re making investment decisions.’