Bond spreads reflect the relative risks of the bonds being compared. The greater the spread, the greater the risk usually is.
People mentioning bond spreads are usually talking about evaluating the return on Govt bonds, usually considered a nation’s most creditworthy bonds, to the bonds of other providers such as regions, cities, or organizations.
Bond spreads can also be determined between bonds of different maturity periods, coupon rates, or even different countries and foreign exchanges. The bond spread symbolizes the difference between bond yields of two countries’. These differences produce carry trade. You will know that currency pairs are going to be headed by tracking bond spreads and objectives of interest rate variations.
As the bond spreads between two financial systems or economies increases, the Forex reserves of the nation with the higher bond yields raise against the other Forex reserves of the nation with the lower bond yield.
You can notice this trend by looking at the information of AUD/USD price movements or activities. The price movements and bond spread can be observed between 10-year Govt bonds of Australia and the U.S from Jan 2000 to Jan 2012.
When the bond spread increased from 0.50 % to 1.00 percent from 2002 to 2004, AUD/USD increased almost 50 percent, increasing from 0.5000 to 0.7000. The same situation occurred in the year 2007, when the bond differential increased from 1.00 percent to 2.50 percent, AUD/USD increased from 0.7000 to more than 0.9000.
Once the economic downturn of the year 2008 came along, and all the significant financial institutions like central banks started to reduce their interest rates, AUD/USD stepped from 0.9000 to 0.7000.
One aspect that performs here is that investors are enjoying the benefits of carry trades and investments. When bond spreads were increasing between the U.S. Treasuries and Australian bonds, investors wrap up on their long positions of AUD/USD.
The purpose of taking these actions is that investors are trying to take benefits of carry trades or investments. However, once the Reserve Bank of Australia reduced interest rates and started to freeze bond spreads, investors renewed their long positions on AUD or USD. They were not very successful.