Lesson 01: Interest Rates and Why Currencies Follow Them

If you learn one fundamental relationship, learn this one. Over weeks and months, currencies move largely with the interest rates attached to them — and specifically with changes in what the market expects those rates to be, which is a very different thing from what they are today.

Nominal and real rates

The nominal rate is the headline number the central bank sets. The real rate is that number after inflation.

Real rate = nominal rate - inflation

What each variable means:

nominal rate — The policy rate, or a market rate like a 2-year government yield
inflation — Usually expected inflation rather than the last reading

The distinction decides which way capital actually moves:

Country A pays far more and loses purchasing power doing it
Country	Nominal	Inflation	Real
A	8%	9%	−1%
B	3%	1%	+2%

Country A's 8% looks attractive and buys less at the end of the year than it did at the start. A foreign investor comparing the two is choosing B, and that decision is what drives the flow.

Note

This is why high-inflation currencies with eye-watering headline rates tend to depreciate rather than attract capital. The rate is compensation for the depreciation, not a free gain — which also explains why the carry trade in lesson 7 is riskier than its yield suggests.

Expectations are priced first

The most common beginner error in this whole track: assuming a rate rise means the currency rises.

Markets price what they expect. If a hike has been expected for six weeks, the currency has spent six weeks moving on that expectation, and by the time the decision arrives there is nothing left to price. What moves the market on the day is the difference between what happened and what was expected.

Expected	Delivered	Likely reaction
A hike	A hike	Little, or a fall on profit-taking
A hike	No change	Sharp fall
No change	A hike	Sharp rise
A hike, with more to come	A hike, and a signal that this was the last	Fall, despite the hike

The last row is the one that confuses people, and it is entirely consistent: the decision matched expectations while the path did not. The path is worth more than the step, because currencies are priced on where rates are going rather than where they are.

Where to see expectations

Rate futures and overnight index swaps price the probability of a move at each upcoming meeting. Several banks and data sites publish this as a percentage.
Two-year government yields are a decent proxy: they embed the expected policy path over that horizon and are quoted continuously.
The spread between two countries' two-year yields tracks their currency pair more closely than either yield alone.

Rate differentials between two currencies

A currency pair is a relative price, so the absolute rate in one country tells you very little. What matters is the differential.

Differential = rate on the base currency - rate on the quote currency

What each variable means:

base — EUR in EUR/USD
quote — USD in EUR/USD

A narrowing differential in the euro's favour pushes EUR/USD up; a widening one in the dollar's favour pushes it down. Crucially, either side can cause the change — the euro does not have to do anything for EUR/USD to move on rates.

What happens	Effect on the differential	EUR/USD
ECB turns more hawkish	Widens in the euro's favour	Up
Fed turns more hawkish	Widens in the dollar's favour	Down
Both turn hawkish equally	Unchanged	Little effect
ECB unchanged, US data disappoints	Narrows against the dollar	Up

Row 3 is worth dwelling on. Two central banks hiking together can leave a pair almost unmoved, and a trader watching one country's news in isolation will find that inexplicable. Currencies are traded in pairs, so the analysis has to be in pairs too.

Good to know

Plot the two-year yield spread against your pair over the last year. The relationship is rarely tight week to week and is usually unmistakable over months — which is a fair description of how useful fundamentals are at each horizon.

Why the actual decision often moves less than the tone

On decision day, the number itself is usually the least interesting part. It was priced. What was not priced is the language around it.

The statement's wording, especially the sentences that changed from last time.
The vote split. A hike passed 5–4 is a much weaker signal than one passed unanimously.
The projections, where the committee publishes where it expects rates to be.
The press conference, where an unscripted answer can reverse the whole move.

The pattern you will see repeatedly: the decision lands, the currency jumps in the expected direction, and then reverses entirely during the press conference forty-five minutes later. Nothing went wrong. The market priced the decision, then re-priced the path.

Caution

This makes central bank decisions genuinely hazardous to trade. The direction depends on wording nobody has read yet, spreads widen, and stops fill badly. Track 5's sizing rules are not optional here — and holding a normal-sized position through one is a decision to accept a much larger risk than the position implies.

The useful takeaway is not a trading signal. It is a lens: when a currency moves for no visible reason, the first place to look is what changed in the expected rate path, because over weeks and months that is what most of the movement turns out to be.

Key takeaways

Capital follows real rates — nominal minus inflation — which is why high-inflation, high-rate currencies still depreciate.
Markets price expectations, so the move comes from the surprise and from the path, not from the decision itself.
Trade the differential between the two currencies in the pair; either side changing moves it.
On the day, the tone, vote split and projections matter more than the number, which is why decisions are dangerous to hold through.

Interest Rates and Why Currencies Follow Them

By the end of this lesson