Interest rate differentials
Lesson 16 · about 9 min
Ask a currency dealer what moves exchange rates over months and years and the first answer is interest rates: not the level in one country, but the difference between two countries, and more precisely the market's expectation of how that difference will change. Everything else in this module hangs off that idea.
Why rates move currencies
Money flows toward yield. If deposits in currency A pay 5% and deposits in currency B pay 1%, investors who hold B have a reason to sell it and buy A, and the exchange rate moves in A's favour until the extra yield is balanced by the risk of A falling later. That flow is the mechanism behind the carry trade from Module 4 and behind a great deal of the medium-term trend in the majors.
| Situation | Expected effect on A/B |
|---|---|
| A's central bank raises rates, B's holds | A/B rises |
| A's central bank cuts, B's holds | A/B falls |
| Both raise by the same amount | Little change |
| A raises less than the market expected | A/B often falls despite the hike |
| A holds but signals hikes ahead | A/B rises |
The last two rows are the ones that confuse beginners and they are the ones that matter. Price does not react to what happened; it reacts to what happened relative to what was already priced.
Expectations are the price
By the time a central bank meets, the futures and swaps markets have already assigned a probability to every plausible outcome. If a 0.25% hike is 95% priced, delivering it moves the currency very little; the trade happened weeks ago as the probability climbed. If the bank hikes 0.25% when the market expected 0.50%, the currency falls on a hike.
This is why "rates went up but the currency went down" is not a paradox. Compare each of these to expectations:
| Event | Market expected | Outcome | Surprise | Typical reaction |
|---|---|---|---|---|
| Fed decision | +0.25% | +0.25% | none | small, noisy |
| Fed decision | +0.25% | hold | dovish | USD falls |
| ECB decision | hold | +0.25% | hawkish | EUR rises |
| BoE decision, 9-0 vote | 7-2 vote for a hike | 9-0 vote for a hike | more hawkish | GBP rises |
| Fed statement wording | "further hikes" | "data dependent" | dovish | USD falls |
Hawkish means tilted toward higher rates or tighter policy; dovish means the opposite.
The differential, in numbers
The interest rate differential is simply one policy rate minus the other. Suppose (illustrative) the US rate is 5.25% and the eurozone rate is 3.75%. The USD–EUR differential is 1.50 percentage points in the dollar's favour. If the market expects the Fed to cut twice (0.50%) and the ECB once (0.25%) over the next year, the expected differential a year out is 1.25 points. A EUR/USD trader is not trading 1.50 versus 3.75; they are trading whether that expected 1.25 will turn out higher or lower.
The 2-year government bond yield in each country is the market's quick summary of expected policy over the next two years. Watch the 2-year yield spread between two countries and you are watching the thing that drives the pair:
| Pair | Yield spread to watch | Direction |
|---|---|---|
| EUR/USD | German 2y minus US 2y | Spread rises → EUR/USD tends to rise |
| GBP/USD | UK 2y minus US 2y | Spread rises → GBP/USD tends to rise |
| USD/JPY | US 2y (or 10y) minus Japan 2y | Spread rises → USD/JPY tends to rise |
| AUD/USD | Australia 2y minus US 2y | Spread rises → AUD/USD tends to rise |
"Tends to" is doing work in that table. The relationship is strong over weeks and months and can vanish for days at a time when something else (risk sentiment, intervention, a political shock) takes over.
Key idea: Currencies price the expected future difference between two interest rates. A move happens when that expectation changes, which is why a fully priced hike does nothing and a smaller-than-expected hike sends the currency down.
Real rates and inflation
Inflation erodes what a yield is worth. A currency with 6% rates and 8% inflation has a real rate of −2%; one with 3% rates and 2% inflation has +1%. Capital prefers the second. This is why inflation data (the next two lessons) moves currencies: higher-than-expected inflation implies the central bank will have to raise rates more, which raises expected nominal rates, which supports the currency, at least until the market decides inflation is a growth problem instead.
What this means for a beginner
You are not going to model yield spreads. You need three habits:
- Know the current policy rate of each currency you trade, and roughly what the market expects it to do over the next six months. A central bank's own site and any major financial news source will tell you.
- Before every central bank meeting on your currencies, know what is priced. If a hike is fully expected, the meeting is about the statement and the guidance, not the number.
- Treat "rates up, currency down" as information, not a mistake: the market expected more.
Try it: For your two or three pairs, write down the current policy rate of each currency and the number of hikes or cuts the market expects over the next year (financial news summaries of "market pricing" will give you this). Compute the current differential and the expected differential a year out. Note whether the pair's trend over the past three months agrees with the direction the expected differential is moving.
Recap
- Money flows toward higher expected yield, so the difference between two countries' rates drives the pair over months.
- Price reacts to surprises relative to expectations, not to the decision itself; a fully priced hike is a non-event.
- The 2-year yield spread between two countries is the market's live summary of the expected differential.
- Real rates (nominal minus inflation) are what capital ultimately chases, which is why inflation data moves currencies.
- Know the policy rate and the priced path for each currency you trade before every central bank meeting.
See it drawn
Original diagrams for the ideas on this page. Illustrative, not real market data.