International economics and factors that affect currency indexes aren’t exactly easy topics to conceptualize. Currency values can change in response to a range of things, from political news to central bank policies. While the science is far from being from perfected (and probably never will be), there are a few key factors that have a proven effect on the dollar index. One that’s particularly well known is government bonds. The dollar tends to move in accordance with these bonds’ prices and interest rates. And while it’s not a foolproof trading strategy, knowledge of Treasury bonds’ effects on the dollar index is one very useful tool in a skilled Forex trader’s arsenal.

How Treasury Bonds Work

Like any other bond, Treasury bonds are a debt instrument that pay an interest rate to their holders. The fact that they are issued by the government, however, gives these bonds some unique qualities. Because it is assumed that the government can tax its citizens enough to always cover interest payments, the interest rate that one receives from holding a treasury bond is referred to as the “risk free rate”, as there is virtually no risk of default - Prof FX.

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Treasury bonds also are unique in that they are the basis for determining the interest rate on U.S. dollars. Generally speaking, raising interest rates on the dollar will lead to increased demand for dollar assets and an appreciation of the currency’s value. Similarly, decreasing interest rates should theoretically decrease demand in the dollar and lead to currency depreciation. Of course, this is chiefly focused on expectations. When speaking in the here and now, a current increase in price and lowering of interest rates on T-bonds indicates increased demand for dollar assets. Similarly, decreasing price and rising interest rates indicate a current condition of weaker demand.

Bonds and Currency Value in the Real World

In general, governments with developed economies like stability. In the current world economic state where the U.S. is a huge importer of foreign goods, the governments of those exporters want to preserve that condition so their country’s businesses can continue making money from the United States. At the same time, countries that import U.S. goods want to continue to do so at a reasonable and stable cost.

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To put this in real terms, consider the following. If inflation were to increase in the U.S. and the dollar depreciated against other currencies, it would become relatively more expensive (in terms of dollars) for the U.S. to import foreign goods. Likewise, if the dollar were to appreciate against other currencies, it would become more expensive for other countries to purchase goods made in the United States. Thus, there are strong forces on both sides of the dollar index equation.

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Putting it All Together

When the dollar looks like it might make a significant, long term move, foreign governments can influence relative currency value through – you guessed it – treasury bonds. If, for instance, inflation is rising and the dollar seems like it might lose value, the purchase of treasury bonds raises price and decreases interest rates, which, in the short term, curbs loss of value. Likewise, dollar increases to the point where governments think the goods they need would become too expensive in their currency’s terms often leads to the sale of their T-bond holdings, which increases supply and works against further appreciation.

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In short, all these complex and intertwined economic factors lead to a definite correlation between the dollar and bond prices. But the type of correlation often changes. In some time periods, the dollar and t-bonds move together, indicating a true change in demand for dollar assets due to economic factors and interest rates. Others, however, show an inverse relationship between the two, indicating attempts to influence the dollar index by the powers that be.

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