Trading conceptsUpdated 2 min readBy the FXNOD team
How do interest rates affect currencies?
Higher interest rates tend to strengthen a currency, because investors earn more by holding assets in it and so buy it. Lower rates tend to weaken it. What moves the market is the change in expectations: a currency often rises before a rate increase and can fall when the increase arrives, if it was already priced in.
The mechanism
A central bank raises its rate
Deposits and bonds in that currency pay more.
Money flows towards the higher return
Investors must buy the currency to buy those assets.
Demand lifts the currency
Against currencies paying less.
The difference matters, not the level
It is the gap between two countries' rates that moves a pair.
Expectations come first
| What happens | Typical reaction |
|---|---|
| A rise, fully expected | Little movement; sometimes a fall as traders take profit |
| A rise, larger than expected | The currency strengthens |
| No change, but a hint of future rises | The currency strengthens |
| A rise, with a hint that it is the last | The currency can weaken |
| A cut, already priced in | Little movement |
This is why the statement and press conference often move the market more than the decision itself.
Why central banks change rates
- Rising inflation leads them to raise rates to slow spending.
- Weak growth or rising unemployment leads them to cut.
- So inflation and employment data move currencies by changing what traders expect the bank to do next.
The exceptions
- A country raising rates because its currency is collapsing or inflation is out of control may not see it strengthen.
- In a crisis, money moves to currencies seen as safe regardless of their rates.
- Real rates, after inflation, matter more than headline ones.
- Government debt, trade balances and politics can outweigh the rate.
The carry trade
Borrowing a low-rate currency to hold a high-rate one earns the difference each day. It works quietly for long periods and unwinds violently when markets turn fearful, which is why high-yielding currencies can fall sharply in a panic. The overnight swap on a forex position is this same rate difference, charged or paid.
For a trader
- Know the dates of central bank meetings for the currencies you trade.
- Expect sharp, two-way moves around them.
- Read the forecast as well as the decision.
Questions people ask
- Does a rate hike always strengthen a currency?
- No. If it was expected, the move may already have happened, and the currency can fall afterwards.
- Which interest rate matters most for forex?
- The United States' rate, because the dollar is on one side of most currency trading.
- What is a swap in forex?
- The overnight charge or credit on a position, reflecting the difference between the two currencies' interest rates.
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