How interest rates affect currencies

Interest rates are one of the most important long term drivers of currency prices. When a central bank raises or cuts rates, or even hints that it might, the value of its currency can move sharply. This guide explains why rates matter, how rate differentials and expectations work, what the carry trade is and how interest shows up in your own trading costs through overnight swaps.

Why interest rates move currencies

A currency is partly a place to hold money. When one country offers a higher return on cash and bonds than another, international investors have a reason to move money into that country, and to do so they must buy its currency. Higher rates therefore tend to support a currency, and lower rates tend to weigh on it, all else being equal.

Central banks set a short term policy rate to steer inflation and growth. The main ones followed by forex traders are listed below. Each publishes a schedule of policy meetings in advance, and those meetings appear on every economic calendar.

Central bank	Currency	Policy committee
Federal Reserve	US dollar (USD)	Federal Open Market Committee (FOMC)
European Central Bank	Euro (EUR)	Governing Council
Bank of England	Pound sterling (GBP)	Monetary Policy Committee (MPC)
Bank of Japan	Japanese yen (JPY)	Policy Board
Swiss National Bank	Swiss franc (CHF)	Governing Board
Reserve Bank of Australia	Australian dollar (AUD)	Monetary Policy Board

Rate differentials

A currency pair compares two currencies, so what usually matters is not one rate on its own but the gap between the two, called the rate differential. If US rates rise while euro area rates stay the same, the differential moves in favour of the dollar, which tends to push EUR/USD lower. If the European Central Bank then raises rates faster than the Federal Reserve, the differential narrows and the pressure can reverse.

Traders often watch two year government bond yields as a guide, because they react quickly to changes in expected policy. A widening gap between US and German two year yields, for example, is commonly read as supportive for the dollar against the euro.

Expectations matter more than the decision

Markets look ahead. By the time a central bank announces a decision, the most likely outcome is usually already reflected in the price, because traders have been positioning for it for weeks. That is why a currency can fall on the day its central bank raises rates: the hike was expected, and the message about future moves was softer than hoped.

What moves prices on decision day is the surprise, which can come from three places:

• The decision itself, if it differs from what was expected.
• The statement and press conference, which indicate the likely path of future rates.
• Updated forecasts for inflation, growth and rates, where the bank publishes them.

Data such as inflation, employment and wage growth feed into those expectations between meetings. A higher than expected inflation reading can strengthen a currency because it makes future hikes more likely. Our market sessions and economic calendar guide explains how to find these releases and their timing.

Hawkish and dovish

Two words come up constantly in rate coverage. A hawkish central bank leans towards higher rates to fight inflation. A dovish one leans towards lower rates to support growth. A shift in tone from dovish to hawkish, even without a change in rates, can lift a currency, and the opposite shift can weaken it.

Real rates

The headline rate is not the whole story. The real interest rate is the nominal rate minus inflation. A country with a 5% policy rate and 6% inflation offers a negative real return, which may be less attractive than a 3% rate with 1% inflation. Real rates matter especially for gold, which pays no interest; our dollar index and gold guide covers that link.

The carry trade

A carry trade means buying a higher yielding currency against a lower yielding one, aiming to earn the rate differential over time as well as any price gain. The yen and the Swiss franc have often been used as low yielding funding currencies.

Carry trades can work for long periods when markets are calm, then unwind quickly when fear rises, because many traders rush to close the same positions at once. The interest earned can be wiped out by a sharp price move in a few days, so carry is never free money.

How interest affects your account: swaps

If you hold a leveraged forex position past the daily rollover, your broker applies an overnight financing adjustment, usually called a swap or rollover. Broadly, holding the higher yielding currency can earn a small credit and holding the lower yielding currency costs a debit, but brokers add their own markup, so both sides of a pair can be negative.

Situation	Typical swap effect
Long the higher yielding currency	Small credit or a smaller charge, after the broker markup
Long the lower yielding currency	A charge for each night held
Position held over the weekend	Many brokers apply three days of swap on one weekday, often Wednesday
Position opened and closed the same day	No swap

Swap rates change as central bank rates change, and each broker publishes its own figures in the platform. Always check them before holding a trade for days or weeks. Forward points in the professional market follow the same logic: the currency with the higher rate trades at a discount in the forward market, so the interest gap is not a free gain.

Using rates in your analysis

• Know the policy rate and the current direction of each central bank behind the pair you trade.
• Check the calendar for rate decisions and key inflation and jobs data.
• Read the statement and press conference for changes in tone, not just the decision.
• Remember that big moves come from surprises, not from expected outcomes.
• Reduce size or stay flat into decisions if you cannot accept a sharp move against you.

Interest rate checklist

• I know which central banks stand behind the pair I trade.
• I know when their next meetings are.
• I understand that expectations are often priced in before the decision.
• I check the swap before holding a position overnight.
• I know that carry trades can unwind quickly.

Frequently asked questions

Why does a currency sometimes fall when rates rise?

Markets price in expected decisions in advance. If a hike was fully expected and the central bank sounds less hawkish than hoped about future moves, the currency can fall on the day.

What is a rate differential?

It is the gap between the interest rates of the two currencies in a pair. A widening gap in favour of one currency tends to support it against the other.

What is a swap in forex?

A swap is the overnight financing adjustment a broker applies when you hold a leveraged position past the daily rollover. It can be a small credit or a charge, depending on the rates and the broker markup.

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