The debt market is a "safe haven" for investors

Dmitry Demidenko, trader, iLearney trainerIn the master class "Be a Trader with iLearney"

Looking at the screen with the graphs quotes In the case of various instruments, you are sometimes amazed at how emotionally the market behaves: consolidations alternate with explosive movements, and a seemingly stable trend abruptly changes its direction. And this is not surprising, because markets are managed by people, be it private investors or hedge fund managers - people who always have room for emotions in their lives.

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Debt market: the first in the financial market in terms of scale

Growing risk appetite against the backdrop of global economic recovery leads to increased demand for risky instruments in the form of shares or debt instruments of countries with relatively low credit ratings. And vice versa, recession forces investors to seek "safe harbors" in the form of the most reliable bonds. In both cases, we are dealing with debt marketwhich, according to experts, is the largest segment of the financial market in terms of scale.

Figure 1. Financial market structure (source: WGC, Deutsch Bank).
Figure 1. Financial market structure (source: WGC, Deutsch Bank).

The volume of transactions with bonds is as follows almost half of the total value of transactions on the spot market. And it is quite logical, because every year the debt of the leading world powers is constantly growing.

Scale of debt markets

In simplified terms, the size of a country's debt market can be estimated based on of GDP and public debt as a share of GDP. Of course, this approach will attract a lot of criticism, nevertheless, we are not trying to find exact figures, but only trying to compare the scale of debt markets in different countries of the world.

Figure 2. Scale of debt markets in the leading countries of the world.
Figure 2. Scale of debt markets in the leading countries of the world.

According to the table above, the largest bond and bill markets are the United States and Japan, whose securities, due to their high credit ratings and low interest rates, are traditionally classified as the most reliable financial market instruments.

However, human nature is such that there will always be those willing to choose the best option from the best options. Especially in conditions when the status of a "safe harbor", as a result of political changes inside the country, is in question.

Currency dynamics and bond yields: close correlation

The coming to power of the liberal democrats in Japan, with their loud slogans about raising inflation targets, led to the the rising yields of government bonds in the Land of the Rising Sun. National investors, including Pension Funds, have begun to gradually withdraw from the market in an effort to diversify its risks associated with a weakening yen. And as one of the possible investment options, US and German debt obligations are considered.

This behavior of market participants provides a new impetus capital flow processincreasing the demand for dollars and euros. At the same time, the dynamics of the currency pair USD/JPY is closely correlated with the yield differential between 10-year U.S. and Japanese bonds.

Fig. 3. Dynamics of USD/JPY currency pair and bond yield differential (in red).
Fig. 3. Dynamics of USD/JPY currency pair and bond yield differential (in red).

Based on this relationship and given the size of the debt markets of these countries, we can conclude that the process of capital spillover between America and Asia largely determines the dynamics of the U.S. dollar/yen exchange rate.

It should be noted that many institutional investors use the following methods to justify trades in the foreign exchange market debt differentials of different countries as a kind of indicator. I am sure that any trader can do the same. After all, all of us, regardless of our status, are subject to the same emotions. Emotions that make markets of different scales move.      

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