How Interest Rate Decisions Move Currency Markets

Interest rates move currencies because a currency is a claim on a stream of returns, and the rate is the return. When one economy pays materially more to hold its currency than another, capital tends to move towards the higher payer. That relationship is the backbone of currency pricing over months, and the way it breaks is what costs people money.

A 10.75% carry, and the week it vanished

Take the classic structure. You borrow in a currency paying 0.25% and hold one paying 11%. The differential is 10.75% a year, about 0.9% a month, credited daily as positive swap. On a position held at five times account equity, that is roughly 4.5% of the account per month arriving whether or not the exchange rate moves at all.

It looks like income. It is not income, it is compensation for a risk that shows up rarely and all at once. A 7% adverse move in the exchange rate over two days, which is an ordinary event in a high-yielding emerging currency during a risk-off episode, costs 35% of the account at that leverage. Eight months of accumulated carry is gone in 48 hours, and the position is still open.

This is why carry returns are described as picking up small gains in front of an infrequent large loss. The distribution has a long left tail. Nothing about the arithmetic is hidden, and the leverage calculator will show you exactly what a given multiple does to a 7% move before you take the trade rather than after.

The differential, not the level

A pair prices the relationship between two rates, so the absolute level of either one tells you little. A currency at 5% versus one at 4% is a 1 point differential. The same currency at 5% against one that has just moved to 5.5% is now on the wrong side of a 0.5 point gap, and the pair can weaken even though the first country's rate has not changed.

What actually drives the exchange rate is the change in the expected differential. Markets price the full path of both rates, typically through two-year government bond yields, which is why the 2-year yield spread between two countries tracks their exchange rate more closely over medium horizons than either policy rate does.

• Watch the spread, not the rate. Two-year yields for both countries, and the difference between them.
• Watch the change in the spread. A widening gap is the signal; a wide but stable gap is already in the price.
• Watch which leg is moving. A spread that widens because one economy is strengthening behaves differently from one that widens because the other is in trouble.