FX · X9 · 9 min
What moves currencies
Explain why a currency moved: interest rates, inflation, what a country sells, fear in markets, or the authorities stepping in.
In the news: A central-bank surprise, a sell-off in shares or a finance-ministry warning: each shows up first in the currency.
The essentials
- Interest rates and surprises
- Higher interest rates, or expected rises, tend to lift a currency, because holding it earns more. What moves it is the surprise against pricing: a rate rise everyone expected barely moves sterling.
- Real rate gap
- Investors compare interest rates after inflation. A 4% rate with 3.5% inflation is 0.5% real, so it trails a 3.75% rate with 2.5% inflation (1.25% real) by 0.75 points, despite the higher headline rate.
- Growth and terms of trade
- Strong growth tends to lift a currency. Commodity exporters gain when the prices of what they sell rise, an improvement in their : the Australian dollar often moves with iron ore.
- Safe havens
- When markets are scared, the dollar, the yen and the Swiss franc tend to rise, and commodity and emerging-market currencies to fall. The yen gains partly as Japanese investors bring money home.
- Intervention and pegs
- is the authorities trading their own currency. Buying it uses reserves, which can run out, and fails if rates push the other way. A lasts when policy backs it, as in Hong Kong.
Real rate gap and real exchange rate
Real gap = (i_A − π_A) − (i_B − π_B); real rate = S × P_base ÷ P_terms
- i
- nominal policy or short-term interest rate in each economy
- π
- inflation: expected, or the latest year
- S
- nominal exchange rate, terms currency per unit of base
- P
- price level in each economy
How it works
1. Money goes where it earns more
If savings in pounds pay 5% and savings in dollars 3%, investors earn more by holding pounds, so they buy them. Higher interest rates, or the expectation of higher rates, tend to lift a currency.
2. Surprises move prices
Markets already price in what they expect. A Bank of England rise that everyone expected barely moves sterling; a cut when traders expected no change sends it lower. Always compare a decision with what was priced.
3. Real interest rates
A high rate isn’t worth much if inflation eats it. The real rate is the interest rate minus inflation: 4% with 3.5% inflation is a 0.5% real rate; 3.75% with 2.5% inflation is 1.25%. Investors compare real rates across countries: here the first is 0.75 points lower.
4. What a country sells
Strong growth tends to lift a currency, through higher expected rates and money flowing into its shares and bonds. A country that exports commodities gains when their prices rise, an improvement in its : the Australian dollar often moves with iron ore.
5. The real exchange rate
Over years, prices matter too. If GBP/USD stays at 1.25 but UK prices rise 4% and US prices 2.5%, British goods get about 1.5% dearer for Americans. That is a rise in sterling’s : the exchange rate adjusted for inflation in both countries.
6. When markets are scared
When share prices fall, investors cut risk. The dollar, the yen and the Swiss franc tend to rise as , while commodity and emerging-market currencies tend to fall. The yen gains partly because Japanese investors bring money home in a scare.
7. Intervention
Sometimes the authorities trade their own currency, called ; in Japan the Ministry of Finance decides and the Bank of Japan does the trades. Buying your own currency uses foreign reserves, which can run out, and it fails if interest rates keep pushing the other way.
8. Pegs and floors
Selling your own currency has no hard limit, since a central bank can create it, but it still has costs: the Swiss National Bank gave up its floor of 1.20 francs per euro in January 2015. A , a promise to hold a rate, lasts when policy is set for it, as with Hong Kong’s band of 7.75 to 7.85 per US dollar.
Worked example
For illustration: UK Bank Rate is 4.00% with inflation at 3.5%; the US policy rate is 3.75% with inflation at 2.5%.
- UK real rate: 4.00 − 3.5 = 0.50%.
- US real rate: 3.75 − 2.5 = 1.25%.
- Real gap, UK minus US: 0.50 − 1.25 = −0.75 percentage points.
- Sterling pays 0.25 points more in nominal terms but 0.75 points less in real terms, so the nominal gap overstates its support.
−0.75 percentage points: the UK’s higher nominal rate is more than used up by its higher inflation.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
Pick a currency pair and tell me what’s driving it right now.
Why does the yen often rise when markets fall?
Why does currency intervention sometimes fail?
Remember
Real gap = (i_A − π_A) − (i_B − π_B)
Currencies follow expected real rate gaps, growth and risk appetite; surprises move them, priced news doesn’t, and intervention lasts only when policy backs it.
Sources
- Bank of Japan — What is foreign exchange intervention? Who decides and conducts foreign exchange intervention?
- Swiss National Bank — Swiss National Bank discontinues minimum exchange rate and lowers interest rate to -0.75%
- Swiss National Bank — After the minimum exchange rate: new monetary policy challenges
- Hong Kong Monetary Authority — How Does the LERS Work?
Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.