Why Interest Rates Dominate Currency Markets
You learned in the basics module that interest rates affect currencies. Now let's understand why they're the single most powerful force in forex—more influential than GDP, trade balances, or political events over the medium term.
The Scale of Interest Rate Flows
Consider the numbers: Global bond markets total over $130 trillion. Even a small shift in allocation—say, 1% of global bond portfolios moving from Europe to the US due to rate differentials—represents $1.3 trillion in currency flows. That's more than 10 days of total forex market turnover, concentrated in one direction.
This is why central bank rate decisions move markets so dramatically. They don't just signal policy—they redirect trillions in capital flows.
The Mechanism: From Rate Decision to Price Move
Central Bank Raises Rates
Example: The Fed raises US rates from 4% to 4.25%. Government bonds now pay more interest.
Rate Differential Widens
If Japan stays at 0.25%, the US-Japan rate gap expands from 3.75% to 4%. US assets become relatively more attractive.
Capital Flows to Higher Yield
Japanese investors, pension funds, and global allocators buy more US bonds. To do so, they sell JPY and buy USD.
Currency Appreciates
Sustained USD buying pressure pushes USD/JPY higher. This isn't a one-day spike—it's a persistent trend as capital continues flowing to higher yields.
Rate Differentials in Practice
Let's look at a real example of how interest rate differentials created one of the strongest currency trends in recent history.
Case Study: USD Strength (2022-2023)
The Setup:
• US Federal Reserve rate: 0.25% (March 2022) → 5.25% (July 2023)
• European Central Bank rate: 0% (March 2022) → 3.5% (July 2023)
• Bank of Japan rate: Remained at -0.1% throughout
The Interest Rate Gap:
The Fed's aggressive 500 basis point hike cycle created massive rate differentials. The US offered 175+ basis points more than Europe and 535 basis points more than Japan—unprecedented gaps in modern forex markets.
(Note: A basis point is 1/100th of a percent. So 100 basis points = 1%. The 500 basis point hike means rates increased by 5%.)
The Result:
EUR/USD
1.12 → 0.96
-14% (euro weakened)
USD/JPY
115 → 151
+31% (dollar strengthened)
DXY (Dollar Index)
+20%
in 18 months
Why It Worked:
Investors globally sold euros and yen to buy US dollars, earning 5%+ annually on dollar deposits versus near-zero on yen. This massive capital reallocation drove one of the strongest dollar rallies in decades—a textbook example of interest rate differentials creating multi-year trends.
Calculating Rate Differentials
Rate differentials are expressed in basis points (bps). 100 basis points = 1 percentage point.
Rate Differential = Country A Rate - Country B Rate
Example: USD rate (5.25%) - JPY rate (0.25%) = +500 bps
Positive = Currency A has higher rates (favors Currency A)
Important Nuance
Don't just look at policy rates. Markets trade on government bond yields, which incorporate rate expectations. Use 2-year yields for near-term outlook and 10-year yields for longer-term positioning.
Rate Expectations: What Markets Price In
Here's a critical insight: markets don't react to rate decisions—they react to changes in expectations. If everyone expects a 25 basis point hike and the Fed delivers exactly that, the currency barely moves. But if they expected 25 and got 50, that's a shock.
The Expectations Game
Currency moves happen when reality differs from expectations. A rate hold can be bullish if markets expected a cut. A rate hike can be bearish if markets expected more hikes to follow but got dovish guidance.
Where to Find Rate Expectations
Fed Funds Futures (for USD)
CME FedWatch Tool shows probability-weighted expectations for each Fed meeting. Free and widely used.
Example: "Markets price 75% chance of a 25bp cut in September"
OIS (Overnight Index Swap) Rates
Available for most major currencies. Shows the market-implied path of policy rates over time.
Used by professionals to see the full rate path, not just the next meeting.
2-Year Government Bond Yields
The 2-year yield closely tracks expected policy rates over the next 2 years. When 2-year yields diverge between countries, currencies follow.
This is the simplest proxy for rate expectations.
Looking Ahead
Understanding rate expectations is crucial, but it requires knowledge of central bank communication and forward guidance. We'll cover how to trade rate expectations in detail in Chapter 4 (Central Bank Policy), where you'll learn to interpret dots plots, SEP forecasts, and tone shifts that create trading opportunities.
Scenario Challenge: Interest Rate Analysis
Apply your understanding of rate differentials and expectations to this real-world scenario:
Market Situation:
- • ECB currently at 3.75%, signals one more 25 bps hike to 4.0% to combat sticky European inflation
- • Fed currently at 5.25%, signals they're "done hiking" and may cut in 6-9 months if inflation cools
- • Current EUR/USD at 1.08, has been trading sideways without clear direction for 2 months
- • Markets expect the rate differential to narrow over the next year
Based on this scenario, what's the most likely directional bias for EUR/USD?