How interest rate differentials move exchange rates

If one factor had to explain the long-run movement of exchange rates, it would be the interest rate
differential. Everything else — employment data, inflation, growth — is ultimately translated by the
market into one question: what does this do to rates?

1. The basic mechanism

Capital flows to where it is paid more for the same risk. When one country’s rates rise relative to
another’s, demand to hold that currency rises and its exchange rate strengthens.

In short: relative rates up → currency up.

2. More important: expectations, not the current level

This is where beginners most often go wrong. The prevailing rate is already in the
price. Markets trade on changes in expectation about future rates.

What follows in practice:

• A central bank raising exactly as
  forecast → the currency can be unchanged or lower.
• Rates held but a signal of raising sooner → the currency rises sharply.

Which is why the press conference usually matters more than the decision.

3. The real rate is the right measure

Real rate = nominal rate − inflation

A country paying 12% with 15% inflation is really paying −3%. International capital
looks at the real number, not the nominal one. This explains how a high-rate country’s currency can
weaken for a long time.

4. Three things you can actually observe

• The 2-year government bond yield — a better read on short-term rate expectations
  than any indicator. The 2-year yield gap between two countries usually tracks the corresponding pair
  closely.
• The probabilities the market is pricing for coming meetings — published openly and
  updated continuously.
• The tone of central bank officials’ remarks — markets react to the wording, not
  only the numbers.

5. In practice: why USD/JPY is the most sensitive

Japan has held rates very low for a long time while US rates have moved sharply. The wide gap makes
USD/JPY almost a direct chart of the US–Japan yield spread.
Trading that pair without watching US Treasury yields means ignoring the main variable.

6. The other side: swap

The rate differential does not only move price; it also decides the
swap you pay or receive each night. The side aligned
with the differential usually receives; the other side pays. On a position held for weeks, that is
large enough to belong in the plan from the start.

This article is for information only and is not investment advice. Conditions and fee levels are published by the brokers and can change at any time — check with the broker you actually use. Leveraged forex and CFD trading carries a high level of risk and can cost you your entire deposit.