Central Bank Interest Rates

How Rate Differentials Drive FX

A currency is, at its simplest, a claim on a short-term interest rate. Hold euros and you earn a euro rate; hold yen and you earn the Bank of Japan's. The difference between those two rates is the carry, and over long horizons the direction of that difference explains more of a major pair's trend than any other single variable.

The important refinement is that the market trades the expected differential, not today's. By the time a central bank actually cuts, the cut has usually been priced for weeks. What moves the currency is the news that shifts the expected path — an inflation print that makes one more cut likely, or a labour report that takes a hike off the table.

Carry trades and funding currencies

When the gap is wide and volatility is low, traders borrow in the low-rate currency and buy the high-rate one, collecting the difference. The yen and the franc have been the classic funding legs for decades. The trade works until it doesn't: carry positions unwind violently when volatility spikes, which is why yen crosses can fall far faster than they rose.

Real rates, not just nominal ones

Two central banks at 3% are not equivalent if one has inflation at 2% and the other at 6%. The real rate — nominal minus inflation — is what determines whether holders are actually being compensated. This is why inflation releases move currencies even when no policy decision is scheduled: they change the real rate immediately.

Reading a decision day

On a policy day, work through four things in order: the rate itself against expectations, the vote split or dissent, the change in the statement language, and the press conference. Each one can reverse the move produced by the previous one, which is why decision days often print a wide two-way range before settling. Our economic calendar covers how the major releases are usually traded.