Currencies follow rate expectations
A currency pair is a tug of war between 2 economies, and the strongest rope is interest rates. Why the expected rate gap moves the pair.
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In this video
- Money flows toward the higher yield, so the gap in rates and bond yields is the main driver of a currency pair.
- Carry trades borrow in a low-rate currency to invest in a high-rate one. They can unwind violently, as in early August 2024.
- The market trades where the rate gap is heading, not where it is today.
- Pair the stronger central bank against the weaker one.
Try it yourself
A tool from the course that fits this lesson. Change the inputs and see how the result moves.
Actual reading
2.8%
Change the expectation.
−0.3pp
Lower than expected
2.8% is 0.3 percentage points below a forecast of 3.1%.
Next videoMacro FirstGold and real yields1:41Gold pays no interest, so it competes with the return on safe money. How real yields, the central bank and fear move gold.
Key terms
- Currency pair
- Two currencies quoted against each other, like EUR/USD. Buying the pair means buying the first currency and selling the second.
- Key interest rate
- The rate a central bank sets for lending to banks. It drives borrowing costs across the economy and is one of the biggest drivers of a currency.
- Hawkish and dovish
- Hawkish: a central bank leans towards higher rates to fight inflation. Dovish: it leans towards lower rates to support growth.
- Bond yield
- The return an investor earns on a bond. Yields rise when bond prices fall. Short-term yields follow rate expectations, long-term yields follow inflation and growth.