Forex · Intermediate · 4 min

Interest rate differentials

You can explain why the gap between two countries' interest rates influences their exchange rate and why expected changes matter more than current levels.

Money seeks yield

A central bank hints that it may raise interest rates sooner than expected. Within minutes, its currency jumps. Nothing has changed in the real economy yet.

The reason is one of the strongest forces in the currency market: money tends to flow where it earns more. This lesson explains how interest rate gaps influence exchange rates, and why expectations matter more than today's numbers.

The gap and its future

The interest rate differential is the gap between the interest rates of two currencies, usually measured with short-term rates or government bond yields of similar maturity.

When one currency pays clearly more than another, deposits, bonds and money market funds in it become more attractive to investors around the world. To buy them, investors need that currency. This demand tends to support the higher-yielding currency.

The low-yielding currency often plays the opposite role: investors borrow in it and invest elsewhere. This is the basis of the carry trade, which the BIS has studied as one channel through which monetary policy affects exchange rates, and which a later lesson covers.

Three points make the picture more realistic:

Expectations lead. Markets price in where rates are likely to go, often months ahead. A rate rise that everyone expects may barely move the currency. A surprise in the expected path of rates moves it much more.
Real rates matter. A high rate in a country with high inflation may pay little after inflation, and can even signal weakness.
Other forces. Growth, risk appetite, trade flows and politics also move currencies. The rate gap is a strong force, not the only one.

That is why currency traders watch central bank decisions, statements and data closely, as the next lessons explain.

Expectations jump

A fictional central bank's policy rate is 4.0%. Markets expect one more increase this year.

New inflation data comes in well above expectations.
Traders now expect two more increases instead of one. Bond yields in the currency rise.
The currency gains 1.5% against others within an hour.

The rate itself has not changed. What changed was the expected future gap to other currencies. When the central bank later raises rates as expected, the currency barely moves.

Common mistakes

Trading the decision instead of the surprise. Expected moves are usually priced in.
Assuming a high rate means a strong currency. It can reflect inflation or risk.
Ignoring real rates. Interest minus inflation often matters more.
Forgetting other drivers. Risk appetite can overpower rate gaps for a while.

The takeaway

Money tends to flow towards higher interest rates. Currencies react most to expected changes in the rate gap, not to the gap itself.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the currency that tends to attract investment flows, all else equal.

Tap the chart.

Higher interest makes deposits and bonds in that currency more attractive, which tends to support it.
2Markets expect a central bank to cut rates, and it does exactly that. What often happens to the currency?

As with all news, the surprise matters. An expected cut is already in the price.
3What is an interest rate differential?

It is often measured with short-term rates or government bond yields of similar maturity.
4Why doesn't the higher-rate currency always rise?

Inflation, growth, risk appetite and capital flows all influence exchange rates.

of 4 correct.