Interest Rates: Why They're #1
Of all the fundamental factors, interest rates are the single most important driver of currency values. Everything else—GDP, employment, inflation—ultimately feeds into what central banks decide to do with interest rates.
The principle is simple: Money flows to where it earns the most interest.
The Golden Rule
Higher interest rates → Stronger currency
If Country A offers 5% interest on savings and Country B offers 2%, investors will move their money to Country A. This increases demand for Country A's currency, making it stronger.
Understanding Interest Rates
What is an interest rate?
The cost of borrowing money AND the reward for saving it. When you save money in a bank, you earn interest. When you borrow money, you pay interest.
What is the policy rate?
The interest rate set by a country's central bank. It's the baseline rate that banks charge each other for short-term loans (called "overnight loans" because they're literally borrowed at the end of one business day and repaid the next morning).
Why overnight loans? Banks need to maintain a certain amount of cash reserves each day. If Bank A is short on reserves at the end of the day, it borrows from Bank B overnight. The policy rate determines the cost of this borrowing—and this rate then ripples through the entire economy, influencing mortgages, car loans, business loans, and savings accounts.
Why do traders care so much?
Because global capital (trillions of dollars) constantly moves around the world seeking the best return. When rates rise in one country, money flows in from everywhere, driving up demand for that currency.
How Interest Rates Control the Economy
Interest rates are the central bank's primary tool for controlling economic activity. But how does changing a single number affect an entire economy? Let's break down the actual mechanisms.
Used to fight inflation and cool down an overheating economy
The Chain Reaction:
Borrowing becomes expensive: When the central bank raises its policy rate, commercial banks must pay more to borrow money. They pass this cost to their customers by raising loan rates.
Businesses borrow less: Companies think twice about taking loans for expansion, new equipment, or hiring when interest costs are high. Fewer loans = less business growth.
Consumers spend less: Higher rates mean expensive mortgages, car loans, and credit card debt. People postpone buying houses and cars. Saving becomes more attractive than spending because you earn more interest.
Demand drops across the economy: With both businesses and consumers pulling back, there's less demand for goods and services.
Prices stop rising (inflation cools): When demand falls, sellers can't raise prices anymore. Some may even lower prices to attract buyers. Inflation slows or stops.
Real Example: In 2022, US inflation hit 9%. The Federal Reserve raised rates from 0.25% to 5.25% over 18 months. Mortgage rates went from 3% to 7%, car loans became expensive, business borrowing slowed. By 2023, inflation had dropped to 3%. The mechanism worked—higher rates reduced demand, which reduced inflation.
Used to stimulate economic growth and create jobs
The Chain Reaction:
Borrowing becomes cheap: When the central bank cuts rates, commercial banks can borrow cheaply and offer lower rates to their customers. Loans become affordable.
Businesses borrow more: Companies take advantage of cheap loans to expand, buy equipment, open new locations. This requires hiring more workers.
Consumers spend more: Low mortgage rates make home buying affordable. Cheap car loans boost auto sales. Credit cards cost less to carry. Saving earns almost nothing, so people prefer to spend or invest.
Demand increases across the economy: More people buying homes, cars, goods, and services. Businesses see higher sales.
Economy grows, jobs increase: To meet higher demand, businesses expand and hire. Unemployment falls. Economic activity accelerates.
Real Example: During the 2008 financial crisis, the US economy was collapsing and unemployment hit 10%. The Federal Reserve cut rates to nearly 0% and kept them there for years. Cheap borrowing helped businesses restart, consumers bought homes again, and employment gradually recovered. Low rates stimulated the economy back to health.
The Trade-Off
Central banks face a constant balancing act. Raise rates too much → you kill growth and jobs. Raise rates too little → inflation runs wild. Cut rates too much → you risk creating inflation or asset bubbles. Cut rates too little → the economy stays weak. This is why central bank decisions are so impactful—they're always choosing between competing priorities, and their choices drive multi-month currency trends.
Real-World Example
Why USD Strengthened in 2022-2023
The Situation (Early 2022):
• US Federal Reserve rate: 0.25%
• European Central Bank rate: 0%
• Bank of Japan rate: -0.1%
What Happened:
The US Federal Reserve started rapidly raising rates to fight inflation. By mid-2023, the Fed rate reached 5.25%—while Europe was at 3.5% and Japan remained near 0%.
The Result:
• EUR/USD fell from 1.12 to below 1.00 (dollar strengthened against euro)
• USD/JPY rose from 115 to 151 (dollar strengthened 31% against yen)
Why This Happened:
Investors around the world sold euros and yen to buy US dollars because they could earn much higher interest on dollar deposits. This massive demand for dollars pushed up its value.
Rate Expectations Matter More Than Actual Rates
Here's a crucial concept: markets are forward-looking. They don't just react to current rates—they price in expected future rates. This is why:
A currency can strengthen even BEFORE rates are raised (if traders expect hikes)
A rate hike can cause a currency to FALL if the market expected an even bigger hike
Central bank language about future policy often moves markets more than actual decisions
Key Takeaway
Watch for changes in rate expectations, not just actual rate changes. If the market thinks rates will rise next month, the currency will often strengthen TODAY in anticipation.
Interest Rate Differentials
You'll often hear traders talk about "rate differentials" or "the spread between rates." This is one of the most important concepts in forex.
What is an interest rate differential?
An interest rate differential is simply the gap between two countries' interest rates. This differential creates the fundamental force that drives capital flows.
Example: If the US rate is 5.25% and the Eurozone rate is 4.0%, the interest rate differential is 1.25% (5.25% - 4.0%).
The larger the differential, the stronger the incentive for capital to flow from the low-rate country to the high-rate country. This is the engine behind many long-term currency trends.
Understanding Yields and Real Returns
As you progress in forex trading, you'll hear professionals talk about "yields" and "real yields." These concepts are essential for understanding how capital actually flows between countries.
What is a yield?
A yield is the return you earn on an investment, typically expressed as a percentage. When investors talk about "yields," they're usually referring to bond yields—the return on government bonds.
Why bonds matter: When a country's interest rates are high, its government bonds also offer high yields. Foreign investors buy these bonds to earn that yield, but first they must convert their currency into the bond's currency—creating demand that strengthens the currency.
Nominal Yield vs Real Yield
This is where it gets important:
Nominal Yield
The stated return. If a bond pays 5%, that's the nominal yield.
Real Yield
The return after accounting for inflation. Formula: Real Yield = Nominal Yield - Inflation
Example: If a bond pays 5% (nominal) but inflation is 3%, your real yield is only 2%.
Why real yields matter more than nominal yields
Inflation erodes purchasing power. Smart investors care about real returns—what they actually earn after inflation.
Example: Country A vs Country B
• Country A: 6% nominal yield, 5% inflation → 1% real yield
• Country B: 3% nominal yield, 1% inflation → 2% real yield
→ Even though Country A has higher nominal rates, Country B offers better real returns. Professional investors will favor Country B's currency.
Looking Ahead
These concepts—nominal yields, real yields, and interest rate differentials—will become even more important when you reach the Advanced Fundamental Analysis module. There, you'll learn how professional traders use real yields to predict capital flows, build carry trades, and identify multi-month currency trends. For now, just understand what these terms mean.
Knowledge Check: Understanding Interest Rate Mechanics
Test your understanding of how interest rates actually affect economies and currencies. These scenarios require you to think through the cause-and-effect chains.
Question 1:
The Federal Reserve announces a surprise 0.50% rate hike, raising rates from 4.50% to 5.00%. However, traders were expecting a 0.75% hike. What is the most likely immediate market reaction, and why?
Reveal answer
USD likely weakens, even though rates went UP.
This demonstrates that markets are forward-looking and trade on expectations, not just events. Here's the mechanism:
Before the announcement, traders had already bought USD expecting a 0.75% hike—they priced it in. When the Fed only raises 0.50%, it's a disappointment relative to expectations. Traders who bought USD at higher prices now sell because the actual outcome is less aggressive than anticipated.
This is why you'll often see "good news" not move a currency if it was already expected, or why "bad news" can actually strengthen a currency if it's not as bad as feared.
Question 2:
Country A has 5% interest rates and 6% inflation. Country B has 2% interest rates and 1% inflation. Based on real yields, which currency should theoretically attract more foreign investment, and why does this matter more than nominal rates?
Reveal answer
Country B should attract more investment.
The calculation:
• Country A: Real yield = 5% nominal - 6% inflation = -1% (you're actually losing purchasing power)
• Country B: Real yield = 2% nominal - 1% inflation = +1% (you're gaining purchasing power)
Sophisticated investors care about real returns—what they can actually buy with their earnings after inflation eats away at the value. Country A might have a higher headline rate, but after accounting for inflation, you're losing money. Country B offers actual positive returns.
This is why currencies with high nominal rates but even higher inflation often struggle (like Turkish Lira), while currencies with moderate rates but low inflation remain strong (like Swiss Franc). It's not just about the rate number—it's about real purchasing power preservation.
Question 3:
The European Central Bank cuts interest rates by 0.25% to stimulate the struggling eurozone economy. At the same time, they announce that "this is the last rate cut, and we expect to hold rates steady for the next 12 months." EUR/USD initially drops 50 pips, then rallies 80 pips within an hour. Explain this price action using what you know about rate expectations.
Reveal answer
The initial drop was the rate cut itself. The rally was the guidance that no more cuts are coming.
This is a classic example of "buy the rumor, sell the fact" or in this case, "sell the cut, buy the pause." Here's what happened:
Phase 1 (Initial drop): The rate cut reduces the return on euro-denominated deposits and bonds. EUR weakens as expected because lower rates = less attractive currency.
Phase 2 (Rally): The key phrase "this is the last cut" signals that the ECB won't continue cutting. Before the announcement, traders may have feared multiple cuts ahead, which would have meant EUR falling much further. By saying "we're done cutting," the ECB removes the fear of continued rate drops.
Markets immediately recalibrate: "Okay, rates are now at X%, and they'll stay there. That's not as bad as rates continuing to fall to X-0.50% or X-1.00%."
This demonstrates that the path forward (rate expectations) often matters more than the single decision itself. EUR rallied because the worst-case scenario (ongoing cuts) was taken off the table.
Question 4:
During a recession, the central bank cuts interest rates to nearly zero to encourage borrowing and spending. However, banks and consumers are afraid of economic collapse, so they refuse to borrow even though loans are cheap. What is this situation called, and why does it break the normal interest rate transmission mechanism?
Reveal answer
This is called a "liquidity trap" or "pushing on a string."
Normally, the interest rate transmission mechanism works like this:
Cut rates → Borrowing becomes cheap → Businesses borrow to expand → Consumers borrow to buy homes/cars → Spending increases → Economy grows
But in a severe recession or financial crisis, fear overrides economic incentives:
• Banks won't lend: Even though they can borrow cheaply from the central bank, they fear businesses will default on loans, so they hoard cash instead of lending it out.
• Consumers won't borrow: Even though mortgages and car loans are at 0-1%, people are terrified of losing their jobs, so they save rather than spend.
• Businesses won't expand: Even though business loans are cheap, companies see collapsing demand and won't invest in new equipment or hiring.
The central bank can drop rates to 0%, but if no one uses that cheap credit, the mechanism breaks. You can't force people to borrow. This happened during the 2008 financial crisis and the COVID-19 crash. When cutting rates fails, central banks resort to more extreme measures like quantitative easing (printing money to buy bonds directly).