Interest rates and the forex market: Currency pairs to watch

As central banks recalibrate monetary policies amid evolving economic challenges, the impact of interest rate changes on global currency values remains a key focus for market participants. A nuanced understanding of the relationship between interest rates, inflation, and forex supply and demand is essential for navigating today’s dynamic market.

Rates & capital flows

Central banks use interest rates as a primary tool to steer economic activity. When rates rise, foreign investors flock to capture higher returns on deposits and bonds, thereby boosting demand for the currency and driving its value upward. Conversely, a rate cut can increase liquidity and reduce the appeal of domestic assets, potentially leading to a weaker currency. This fundamental supply-and-demand mechanism underpins much of the movement in the forex market.

Cycle dynamics

The interest rate cycle reflects how central banks adjust rates to balance growth and inflation. A rate hike often contracts money supply by increasing loan costs, while a cut makes borrowing cheaper and injects liquidity into the market. These adjustments not only affect consumer behavior but also reshape the competitive landscape for currencies globally, as investors recalibrate their expectations based on policy signals.

Inflation's role

Inflation plays a critical part in monetary policy decisions. High inflation erodes purchasing power, prompting central banks to raise rates to stabilize prices. Conversely, low inflation can lead to lower rates and stimulate spending. Historical trends reveal that when inflation exceeds targets—commonly around 2%—central banks tend to tighten monetary policy, influencing forex markets as investors adjust their outlook on future currency performance.

Market sentiment

Beyond hard data, market sentiment significantly impacts forex pricing. Traders react not only to the actual rate changes but also to the tone and forward guidance provided during central bank meetings. Anticipation of policy moves can lead to pre-emptive repositioning, causing immediate shifts in currency demand and creating short-term volatility.

Key drivers

Currency values are determined by a blend of factors:

• Interest rate differentials: A higher rate compared to a trading partner’s benchmark often results in currency strength.
• Economic fundamentals: Robust GDP growth, stable employment, and manageable inflation support a strong currency.
• Market perception: Investor sentiment, shaped by both quantitative data and qualitative insights, further influences currency demand.

Currency focus

One illustrative example of a trade idea based on rate differentials can be seen in the recent dynamics of the EUR/USD pair. Since April 2024, the EUR/USD had been on a steady upward trajectory as market participants anticipated global rate cuts. In September, the Federal Reserve unexpectedly trimmed rates by 50 basis points following a significant downgrade in jobs data, which led traders to expect a more aggressive rate cut path from the Fed compared to the ECB. This move initially weakened the US dollar, propelling EUR/USD to a high of 1.1200. However, the narrative quickly reversed as an impressive Q3 GDP print for the United States, contrasted with tepid growth in the Euro Area—particularly due to underperformance in Germany—sent the pair spiraling downward. The shift was further accentuated by the US election results, where market sentiment pivoted on expectations of fewer rate cuts in the US amid tariff concerns, while the Euro Area remained under pressure with more aggressive cuts anticipated. This divergence is underscored by the concept of implied interest rates—the differential between current rates and forward rates. For instance, with the Fed's current rate at 4% and a forward rate projected at 3.5%, the implied rate suggests a 50 basis point decline. Moreover, market projections indicate that by December 2025, the ECB is expected to cut rates by around 145 basis points compared to a cumulative 77 basis points from the Federal Reserve, setting the stage for potential US dollar strength as rate differentials widen.

Examining USD/JPY reveals a notable divergence in monetary policy. The Bank of Japan appears poised to consider more rate hikes, whereas the Federal Reserve may opt to pause or even cut rates if inflation surges again. This split in policy could pave the way for an upward move in the Japanese yen.