How inflation moves marketsInflation fell and the market sold off. Inflation rose and shares rallied. Both happen regularly, and neither is irrational once you know what the number is being measured against.How interest rates move currencies
A central bank raises rates and the currency falls. This happens constantly, it is not a malfunction, and the reason is the single most useful thing to understand about macro trading.
The textbook version is simple. Higher interest rates make a currency's assets more attractive, capital flows in, the currency strengthens. It is not wrong, and it explains almost nothing about what actually happens on the day.
What is missing is that markets do not wait. By the time a central bank announces a decision, traders have spent weeks positioning for what they think it will be. The announcement only moves the price to the extent it differs from that.
Markets do not trade the decision. They trade the distance between the decision and what was already assumed.
A rate rise that sinks the currency
Nothing unusual happens here. The bank raises rates, exactly as it said it would, and the currency falls all afternoon.
Three weeks before
- Current policy rate
- 4.00%
- Market pricing
- A rise to 4.50%
- The currency
- Already strengthening on that expectation
The rise is being bought in advance. This is what priced in means.
Decision day
- Announced rate
- 4.25%
- Direction
- Up: policy genuinely tightened
- Against expectations
- Half the increase the market had priced
Rates rose. Relative to what was assumed, the bank was less aggressive than believed.
The repricing
- Expected future rates
- Revised down
- Bond yields
- Falling
- The currency
- Selling off
Everyone positioned for 4.50% now has to unwind. The selling is the unwind, not a verdict on the economy.
The press conference
- Governor's tone
- Cautious about further increases
- Market read
- The cycle may be finished
- The currency
- Extends lower
The statement and the press conference frequently matter more than the number, because they reset the whole expected path rather than one meeting.
Reverse it and a rate cut can lift a currency: if the market expected half a point and the bank delivers a quarter, policy just came in tighter than assumed.
Hawkish and dovish are about direction of change
Hawkish means leaning toward tighter policy - more worried about inflation. Dovish means leaning toward easier policy - more worried about growth or employment.
The important part is that a bank can become more hawkish without touching rates. It leaves the rate at 4.00% but changes its language from "further tightening is unlikely" to "further tightening may be necessary". Nothing happened to the policy rate. Everything happened to the expected path, and the currency can move sharply on a decision that changed nothing.
Why a pair needs two central banks
A currency pair is a comparison, so a single country's rate tells you almost nothing on its own. What moves EUR/USD is the changing gap between two expected paths.
| What changes | Effect on the differential |
|---|---|
| Fed expected to cut, ECB expected to hold | US advantage narrows: supports EUR against USD |
| Fed expected to hold, ECB expected to cut | US advantage widens: supports USD against EUR |
| Both expected to cut by the same amount | Differential unchanged: little directional pressure from rates |
| Fed cuts as expected, but signals fewer cuts ahead | Expected path shifts higher: can support USD despite the cut |
This is monetary-policy divergence, and it is the closest thing forex has to a durable directional driver. It is also why watching only one economy is watching half the trade.
Real rates, not nominal ones
A 10% interest rate sounds decisively better than 5%. If the first country has 15% inflation and the second has 2%, the first is paying about −5% in real terms and the second about +3%.
Investors care about what a return is worth after inflation. This is why a high-inflation currency with headline rates far above everyone else's can keep weakening: the nominal number is attractive and the real one is not.
Carry, and why it is not free money
The carry trade borrows a low-yielding currency to hold a high-yielding one, collecting the difference. The arithmetic is genuinely attractive and it is also the whole problem.
A 4% annual differential
- High-yield currency pays5%
- Low-yield currency costs1%
- Annual carry5% − 1%+4%
- Exchange rate moves against you−8%
Net result−4%A full year of carry erased by an exchange-rate move that took a fortnight. Carry trades unwind fast and together, because everybody is in the same one.
What the differential actually pays you
Retail swap is not the central bank differential. It is the broker's price, built from a benchmark rate plus its own adjustment, and a large minority of brokers will remove it entirely on request.
- 63of 100 offer swap-free accountsUsually as Islamic accounts. The financing simply is not applied.
- 21do notSo on roughly a fifth of our records, overnight financing is unavoidable on a held position.
- 3×the usual Wednesday chargeMost brokers apply three days of financing on one night to cover weekend settlement.
Never assume positive carry from a rate table. Check the actual swap on the actual pair at your actual broker, in both directions. They are not symmetrical.
Why this matters even if you never hold overnight
A scalper who is flat by the close does not care about carry. They should still care about rate decisions, because those are the moments when spreads widen, liquidity thins and slippage becomes real.
A stop ten pips away is a working stop on an ordinary Tuesday. Thirty seconds after a central bank surprise it is inside the noise, and it will not fill where you put it. The rate environment matters to short-term traders through execution rather than through financing.
Before a central bank decision
Six questions. The third is the one most people skip and the one that decides the reaction.
- What is the current policy rate for both currencies in the pair?
- What has the market priced for this meeting?
- How much of that is already in the price. Has the pair been trending into it?
- Is there a statement, projections or a press conference following the decision?
- What did the bank say last time, and what would count as a change of language?
- Is my position size appropriate for a session where spreads widen and stops slip?
Common questions
Do higher interest rates always strengthen a currency?
No. What matters is the change relative to expectations, and whether the real rate after inflation is attractive. Persistent inflation can weaken a currency despite high headline rates.
Why did the currency fall after a rate rise?
Most commonly because the rise was smaller than the market had priced, or because the accompanying guidance suggested fewer increases ahead.
What does priced in mean?
That current prices already reflect an expected outcome, so the event itself produces little movement unless it differs from that expectation.
What is monetary-policy divergence?
Two central banks moving, or expected to move, in different directions. It widens the rate differential between their currencies.
What is a real interest rate?
The nominal rate adjusted for inflation. Roughly, the nominal rate minus the inflation rate.
Does swap equal the interest rate differential?
No. Brokers build swap from a benchmark plus their own adjustment, and the two directions on a pair are not mirror images. Check the actual published figures.
Can a currency move when rates are left unchanged?
Frequently. The statement, the projections and the press conference can shift the expected path substantially without any change to the current rate.
Does a carry trade guarantee a profit?
No. The exchange rate can move far more than the interest differential pays, and carry trades tend to unwind quickly because crowded positioning exits at once.
Why do forex traders watch bond yields?
Because yields update continuously and contain the market's live estimate of future policy, whereas the policy rate only changes at scheduled meetings.
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