Why interest rates move currencies

Interest rates are the biggest single driver of currency values over weeks and months.

The basic idea

Big investors want the best return for the risk they take. If one country's interest rates rise while another's stay put, holding the first country's currency starts to pay more. Money flows towards it, and its value tends to rise.

That's why traders hang on every word from central banks like the US Federal Reserve, the European Central Bank and the Bank of England. It isn't only the decision that matters, but hints about what comes next.

Inflation and rates

Central banks raise rates to cool inflation and cut them to support growth. So inflation data, especially CPI, moves markets because it changes expectations about future rates:

• Inflation higher than forecast often lifts the currency, because a rate rise looks more likely.
• Inflation lower than forecast often weakens it.

Gold is different

Gold pays no interest. When real yields, meaning interest rates after inflation, rise, holding gold becomes less attractive compared with bonds, and gold often weakens. When real yields fall, gold is often supported.

Expectations beat surprises

Markets price in what they expect. A rate rise everyone saw coming may barely move the price. What moves markets is the gap between what was expected and what happened.

Key points

• Higher or rising rates tend to support a currency.
• Inflation data matters because it shifts rate expectations.
• Watch the difference between forecast and actual, not just the number.