Interest Rates and Exchange Rates: How They're Connected

Interest Rates and Exchange Rates: How They're Connected

Few relationships in global finance are more important, or more misunderstood, than the connection between interest rates and exchange rates. When a central bank raises or cuts rates, currency markets react within seconds. Understanding why this happens and how the mechanism works is essential for investors, business owners, and anyone who deals with foreign currencies.

The Basic Mechanism

At its core, the connection is straightforward: money flows to where it earns the highest return. When a country raises interest rates, its bonds and bank deposits become more attractive to global investors. To buy those assets, investors must first buy the local currency, which increases demand and pushes the currency higher.

Higher interest rates → more capital inflows → stronger currency Lower interest rates → less capital inflows (or outflows) → weaker currency

This is the textbook explanation, and it holds true more often than not, though the real world adds plenty of complexity.

Interest Rate Differentials: The Key Metric

What matters is not the absolute level of interest rates in one country, but the difference between rates in two countries. This is called the interest rate differential.

Current Rate Differentials (Early 2025)

Central Bank	Policy Rate	Differential vs. USD
Federal Reserve (US)	4.25–4.50%	—
ECB (Eurozone)	2.75%	-1.50 to -1.75%
Bank of England (UK)	4.50%	+0.00 to +0.25%
Bank of Japan	0.50%	-3.75 to -4.00%
Reserve Bank of Australia	4.10%	-0.15 to -0.40%
Swiss National Bank	0.50%	-3.75 to -4.00%
Bank of Canada	3.00%	-1.25 to -1.50%

The larger the differential in favor of a currency, the more attractive it is to yield-seeking investors. This is why the Japanese yen (with a 4% disadvantage to the dollar) has been persistently weak, while the British pound (with rates near US levels) has been relatively stable.

The Carry Trade

The carry trade is the most direct expression of the interest rate–exchange rate link. It involves borrowing in a low-interest-rate currency and investing in a high-interest-rate currency to capture the differential.

How a Carry Trade Works

1. Borrow 100 million yen at 0.5% interest
2. Convert to US dollars (sell JPY, buy USD)
3. Invest in US Treasury bills at 4.5%
4. Earn the 4.0% differential (minus transaction costs)
5. After one year, convert back to yen and repay the loan

If the exchange rate stays constant, the trader pockets roughly 4.0%. The catch is that exchange rates do not stay constant.

Carry Trade Risks

The carry trade works beautifully in calm markets but can unravel violently during periods of stress. When risk appetite drops, carry traders rush to unwind positions simultaneously:

1. They sell high-yielding currencies
2. They buy back low-yielding currencies (especially JPY and CHF)
3. This creates a self-reinforcing spiral

Notable carry trade blowups:

• October 1998: Long-Term Capital Management crisis sent USD/JPY from 136 to 112 in two days
• August 2007: Subprime crisis triggered a massive yen rally (15% in weeks)
• March 2020: COVID panic sent USD/JPY from 112 to 101
• August 2024: BOJ rate hike triggered USD/JPY drop from 161 to 141 in three weeks

The carry trade is sometimes described as "picking up pennies in front of a steamroller" because the steady interest income is small compared to the potential loss from a sudden currency move.

Central Banks: The Rate Setters

Central banks are the most powerful force in currency markets because they set the baseline interest rate for an entire economy.

How Central Bank Decisions Move Currencies

It is not just the rate decision itself that matters but how it compares to expectations. Markets are forward-looking and price in expected rate changes well before they happen.

Scenario	Currency Impact
Rate hike, as expected	Minimal (already priced in)
Rate hike, unexpected	Strong appreciation
Rate cut, as expected	Minimal
Rate cut, unexpected	Strong depreciation
Hawkish guidance (hinting at future hikes)	Moderate appreciation
Dovish guidance (hinting at future cuts)	Moderate depreciation

The most significant currency moves often come from changes in forward guidance rather than actual rate decisions. A central bank that holds rates steady but signals that cuts are coming can weaken its currency more than one that actually cuts rates but signals it is done.

The Fed's Outsized Influence

The US Federal Reserve has a disproportionate impact on global currencies because:

• The US dollar is the world's primary reserve currency (roughly 58% of global reserves)
• Most commodities are priced in dollars
• Approximately 88% of all forex transactions involve the dollar
• US Treasury securities are the benchmark "risk-free" asset globally

When the Fed raises rates, it does not just strengthen the dollar. It tightens financial conditions globally, potentially destabilizing countries with dollar-denominated debt.

The Uncovered Interest Parity Puzzle

Economic theory predicts that the carry trade should not generate excess returns. According to Uncovered Interest Parity (UIP), the high-interest-rate currency should depreciate by exactly enough to offset the interest rate advantage. In theory, a 4% rate differential should lead to 4% depreciation of the higher-rate currency.

In practice, UIP consistently fails. High-interest-rate currencies tend to depreciate by less than the differential, and sometimes they even appreciate. This is the "forward premium puzzle" and it is one of the most well-documented anomalies in finance.

Why UIP fails:

• Risk premiums: Investors demand compensation for taking currency risk
• Momentum: Capital flows create self-reinforcing trends
• Central bank credibility: Strong institutions attract capital beyond what rates alone would justify
• Delayed adjustment: Markets are slow to price in long-term equilibrium values

Real Interest Rates vs. Nominal Interest Rates

Nominal interest rates (the headline number) tell only part of the story. What ultimately matters for currency values is the real interest rate: the nominal rate minus inflation.

Real Interest Rate Comparison (Early 2025)

Country	Nominal Rate	Inflation	Real Rate
United States	4.50%	2.8%	+1.7%
Eurozone	2.75%	2.4%	+0.35%
United Kingdom	4.50%	3.0%	+1.5%
Japan	0.50%	2.8%	-2.3%
Switzerland	0.50%	1.1%	-0.6%

Japan's deeply negative real rate explains much of the yen's weakness despite the BOJ's rate hikes. Even at 0.50%, Japanese rates are well below inflation, making the yen unattractive in real terms.

The Expectation Channel

Currency markets trade on expectations of future rates, not current rates. This is why currency movements often seem disconnected from current rate levels.

Reading the Futures Market

Interest rate futures and overnight index swaps (OIS) reveal what the market expects central banks to do over the next 12–24 months. These expectations drive currency movements more than current rates.

Example of expectation-driven moves:

In late 2023, markets began pricing in aggressive Fed rate cuts for 2024 (up to six cuts). The dollar weakened sharply even though the Fed had not cut yet. When the actual cuts were fewer than expected, the dollar strengthened back.

The lesson: currencies move in the direction of changing expectations, not in the direction of current rate levels.

Practical Implications

For Investors

• When you see a central bank signaling rate hikes, the currency has likely already strengthened by the time the hike happens.
• The biggest opportunities come from shifts in expectations, especially when the market is leaning heavily in one direction and the central bank surprises.
• Do not chase yield blindly. A 10% interest rate in a country with unstable monetary policy is more likely to end in currency devaluation than profit.

For Businesses

• Lock in exchange rates with forward contracts when rate differentials favor you.
• If you are paying expenses in a high-rate currency, delay payments (the currency may weaken). If you are receiving income in a high-rate currency, delay conversion (the currency may hold or strengthen).
• Monitor central bank meeting calendars and avoid large unhedged exposures around meeting dates.

For Travelers

• Plan major currency exchanges around central bank meeting cycles.
• If you are traveling to a country that just raised rates, expect a stronger local currency (more expensive trip).
• Countries with falling rates may offer better exchange rates for visitors.

Key Takeaways

1. Interest rate differentials are the single most important driver of exchange rates over medium-term horizons.
2. The carry trade profits from rate differentials but carries significant crash risk.
3. Real interest rates (adjusted for inflation) matter more than nominal rates for long-term currency valuation.
4. Markets price in expected rate changes in advance; currencies move on surprises and shifts in expectations.
5. The Fed has outsized global influence because of the dollar's role as the world's reserve currency.

Understanding the interest rate-exchange rate connection gives you a powerful framework for anticipating currency movements and making smarter financial decisions.

Track how rate decisions affect currencies in real time using the exchange rate tools at hwanyul.com.