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Bond spreads are a very popular and helpful indicator in foreign currency trading.  However, they are not an indicator of rapid and sudden change, but rather a cue as to what will eventually happen, perhaps a year into the future.

That's exactly why bond spreads are called a "leading" indicator, because they lead the event, rather than following it like a moving average or other indicators do by their nature.

A bond spread is typically viewed on the difference between the five year, and the ten year, bonds of two currencies.  For instance, if you are studying  the Euro and the US Dollar, you would need to look at the spread, or difference, between the yields for the bonds of both the Euro and of the US Dollar.

Whichever currency in the pair has the higher interest rate is likely to be favored for the benefit of that interest.  However, be careful to look at a chart of historical data to make sure the spread is increasing and not decreasing.

The way this is used as an indicator is really simple.  When the spread reaches its highest, or its lowest point, and begins to turn in the other direction, you can expect the value of the currencies involved to follow suit at some point later on.  Sometimes the delay between the turnaround in spreads and the turnaround in currency valuation is as much as a year.

Some exceptions to this indicator have occurred.  The Japanese Yen continued to gain value even though Japanese bonds were suffering from the recently ended zero interest rate policy, or ZIRP. The reason for this was that, despite the interest rate, Japanese equity markets, especially stocks, were climbing in value, and therefore attracted much international investment.

This demand for Japanese equities led to an equal demand, and therefore an appreciation, in the Yen.

It is important to note here that bond spreads are not going to do you much good if you are a day trader or other form of short-term trader.  For this type of indicator to work, you must plan on staying the course for as little as six months, and up to perhaps a year or more.

Therefore, you should not enter a trade with high leverage using this indicator. Shorter term fluctuations could flush you out well before the true appreciation of this indicator could be realized.

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