Central banks, interest rates and currencies

If one force explains most big currency moves, it is interest rates, and interest rates are set by central banks.

Why rates move currencies

Higher interest rates make a currency more attractive to hold, because deposits and bonds in it pay more. When a central bank raises rates, or signals that it will, money tends to flow in and the currency strengthens. When it cuts or hints at cuts, the reverse usually happens. Markets move on expectations, so the surprise relative to forecasts often matters more than the decision itself.

The banks that matter most

• Federal Reserve (US dollar), whose decisions ripple through every market.
• European Central Bank (euro).
• Bank of Japan (yen), long an outlier with very low rates.
• Bank of England (pound), Swiss National Bank (franc), and the central banks of Australia, Canada and New Zealand.

What traders watch

Beyond the rate decision itself, traders read the statement, the press conference and the projections for clues about the next move. Inflation and employment reports matter because they shape what central banks will do next. Our economic calendar lists these releases for the week ahead.

The carry trade

Borrowing in a low-rate currency to hold a high-rate one earns the interest difference, known as carry. It can work for long periods and then unwind violently when markets panic and investors rush back to safe havens. The yen has been the classic funding currency for this trade.