How Interest Rates and Currencies Affect Government Bond Returns

The effect of interest rates

From a technical perspective, interest rates are the primary driver of government bond performance, reflecting the fundamental principle that bond prices move inversely to borrowing costs. When interest rates rise, government bond prices tend to fall; when rates decline, bond prices typically rise.

When interest rates rise, newly issued bonds generally enter the market offering higher yields. Existing bonds with lower coupons may therefore become less appealing, putting downward pressure on their prices. The opposite can occur when interest rates fall, as existing bonds with higher coupons may become more valuable.

Maturity matters

• Shorter-dated government bonds (typically one to three years) tend to be less sensitive in price terms to changes in interest rates. Because investors recover their principal sooner, they are able to reinvest their capital at higher yields sooner. This can make short-dated bonds relatively resilient during periods of rising interest rates.
• Longer-dated bonds (generally 20 to 30 years) are more sensitive to expectations around future interest rates, inflation, and the additional compensation investors demand for holding bonds over longer periods (known as term premia). When interest rates rise rapidly, long-dated bonds are typically more vulnerable to negative returns as price declines can outweigh coupon income.

However, sensitivity works both ways. When rates are falling, long-duration bonds have historically tended to exhibit stronger price appreciation because their prices are more responsive to changes in yields.

Changes in interest rates also affect the shape of the yield curve, which is commonly referenced as one indicator of market expectations. Typically, the yield curve plots bond yields across maturities ranging from a few months to 30 years.

• A steep yield curve suggests the market expects stronger growth, with policy rates rising over time and/or higher term premia
• An inverted curve has often been associated with expectations for future policy rate cuts, often associated with weaker economic growth.

The influence of currency movements on government bond performance is sometimes underestimated, particularly by investors allocating internationally. Unfavourable currency moves can at times turn an otherwise positive bond return negative, which is why many global government bond strategies may choose to hedge currency exposure.

Why currencies move

Currencies fluctuate for a range of reasons, most commonly due to changes in expectations for economic growth, inflation and central bank policy.

• A strong currency often reflects stronger growth expectations, higher real interest rates, tighter monetary policy and lower inflation risk
• A weak currency typically signals weaker growth expectations, lower real rates, higher inflation risk and capital outflows

Implications for international investors

For investors whose assets and liabilities are denominated in the same currency, direct currency exposure is generally less relevant. However, for those seeking foreign exposure, currencies become an important source of both opportunity and risk. Potential currency shifts must be factored in, as unfavourable moves can materially alter total returns, particularly in unhedged portfolios. On the other hand, investors must also consider the cost of hedging, which can reduce the net yield advantage of investing abroad.

Moreover, currency movements can, at macroeconomic level, influence investment opportunities in the bond market. If a currency weakens sharply or persistently, foreign investor demand for that market’s government bonds may fall, potentially pushing yields higher. Currency depreciation can also raise import costs, which may put upward pressure on bond yields as inflation increases. As a result, currency movements, investor demand and inflation expectations are closely linked when assessing the outlook for foreign government bonds.

The role of the U.S. dollar

A significant portion of global debt is priced in U.S. dollars so sentiment towards dollar-denominated bonds is often closely linked to the dollar's relative strength.

• When the dollar appreciates, it generally weighs on government bonds outside the U.S. A strong dollar tends to attract capital to U.S. Treasuries, which may put upward pressure on yields in other markets due to capital flight, and increasing debt servicing costs, particularly for emerging markets with U.S. dollar liabilities.
• When the dollar depreciates, debt burdens tend to ease, which can support the performance of international and non-USD bonds.

The U.S. dollar, like the Swiss franc, is widely viewed as a safehaven currency. During periods of market stress, global capital often flows into U.S. Treasuries and Swiss government bonds, boosting their performance relative to bonds issued in more risk-sensitive currencies.

Government bond performance is shaped by a combination of interest rate movements, yield curve dynamics and currency fluctuations. Bond sensitivity to rate changes varies significantly by maturity, making duration and yield curve positioning key considerations for portfolio construction. For international investors, currency exposure adds an additional layer of complexity: in unhedged portfolios, currency movements can dominate return outcomes, while hedging costs can materially affect portfolio yields. Together, interest rates and currencies play a central role in determining the risk and return profile of global government bond investments.