The yield curve is one of the best indicators of current economic conditions as perceived by the bond market. It is crucial for the pricing of many financial derivatives, as well as consumer credit and mortage rates for ordinary borrowers; as such, any analysis of a national economy will incorporate the yield curve data in order to reach at more solid and reliable conclusions.

Data from the yield curve is used widely by economists in order to predict future economic trends. The Dallas Federal Reserve Bank, for example, uses the Neftci Recession Indicator for identifying high-risk periods for future economic contraction, which is constructed partly on the basis of the yield curve. In addition, central bank authorities attach important value to the signals emitted by the yield curve in evaluating the so-called inflation expectations of the public. Although inflation-indexed securities present a higher degree of relevance in this respect, the difference between two-year and ten-year yields, for example, can be a good indicator of future inflation expectations as they stand at the moment.

From the point of view of forex traders, interest rate theories are useful for formulating fundamental strategies. Since currency trends are strongly dependent on perceptions about future rates, as well as present yield differentials between nations, comparing the yield curves of two nations will give us a better idea on the attractiveness of a particular currency for a particular profile of investors. Many hedge funds, for example, are active in the short-end of the yield curve, and also trade the spot forex market, so their behavior will tend to reflect differentials in the short-term market. Others, such as mutual funds, tend to seek safety over risk in usual circumstances, and their unleveraged funds will tend to be concetrated a bit further to the right of the yield curve (towards longer maturities). Depending on the general conditions of the market with respect to the availability of liquidity, the popularity, and ease of speculation, as well as the phase that economic activity is going through, the additional activity generated by one or more of these groups may create enough momentum to become the main thrust of forex trends. Thus, the claim of the preferred habitat theory, that market participants have favored segments of the market and tend to concentrate their activity in them, helps us explain why at different times different actors drive trends in currency trading. This assumption will then naturally lead to the conclusion that not every forex trend is as solid, or fundamentally justified (in contrast to speculatively justified) as another. Where trends are created and driven by borrowed money, invested in short-term assets with the purpose of making quick profits (as in hedge fund activities in some developing world economies), it is clear that the degree of risk and volatility is higher, and lower leverage must be used with a more conservative allocation of capital.

In general, borrowers tend to seek longer terms, as lenders seek shorter maturities, due to obvious reasons of self-interest. The preferred-habitat theory explains that if a lender habituated to longer maturities lends at a shorter term, the cause must be a qualitative advantage in the creditworthiness of the borrower, or, of course, his promises of higher yield. This also explains why nations always prefer to borrow at longer maturities, with as low rates as possible. Apart from being a matter of sound fiscal management for a national economy, longer maturities also signify the market's trust and confidence in the borrowing economy. Without a clear and well-communicated strategy for future growth, a nation will be unable to find reliable long-term creditors, and may instead revert to policies that instead depend on the carry trade, with varying consequences, but often with significant disadvantages in the long run, such as bubbles, large trade deficits, and financial sector instability.

At a more basic level, however, understanding the yield curve provides new methodologies for both short and long-term trading. For example, on a typically quiet day when the USDJPY pair is trading with subdued momentum, rising or falling bond yields across the curve will alert knowledgeable forex traders to the fact that the forex market (as well as the commercial paper, stock, and commodities markets) will soon follow suit and experience higher volatility. It is then possible to take a long or short position and maintain it in order to exploit the signals of the bond market. Or conversely, it is possible to expect developments in the currency markets to be reflected in the shape of the yield curve, which would then have an impact on the stock market, leading to long-lasting trading opportunities. Indeed, these markets mirror each other with remarkably accuracy, and violence and exaageration at times. Developments in one market in one part of the world may be followed by rapid and strong reactions at another place where they would be regarded irrelevant or unlikely at first sight.

We assume that the vast majority of forex traders are aware that interest rates are exceptionally important in determining forex trends. Yet a more accurate description would be one that would subsitute the words "interest rates" with the yield curve. To be sure, forex market action is not generated exclusively by short-term traders, and for many, the short term rates, as communicated by the Fed, have only a limited relevance. Indeed, central bankers often lament publicly that their tools can only impact short term yields such as the overnight rate, and the three month rate. Beyond the three month period, almost no uncollateralized lending is possible, and as a result, the yield curve itself is the main gauge for everything, including mortage lending, industrial and commercial credit, as well as, many other types of financial activity. In this context, we will conclude by noting that a forex trader who desires to acquire a more solid and complete understanding of forex trends must become acquainted with the yield curve first, and grasp its mechanisms in order to gain the necessary competence in evaluating the forex market action.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.