How interest rates create trading opportunities & what drives currency movements

In the intricate world of global markets and finance, interest rates wield significant power over currency values, influencing economic conditions far beyond national borders. But how exactly do interest rates affect currencies, and why should you care? Let’s dive into the fascinating dynamics of this relationship and uncover how central banks use interest rates to shape global exchange trends.

Interest rates are the cost of borrowing money in a country, and they're linked to global rates. They can be what banks charge each other to borrow money or what they pay when borrowing from the central bank.

Interest rates play a crucial role in the global economy as they tend to have a trickle down effect, both on the interest rates of other countries and spending habits of consumers. In short, interest rates are a tool used by central banks to control the supply and demand of a country's currency.

The interest rate cycle is about how a country's central bank changes interest rates to help manage the economy. These changes aim to keep the economy stable and encourage growth.

The relationship between interest rates and foreign exchange rates is based on supply and demand. When demand is high, prices typically rise, and when there is too much supply, prices usually fall. This is a very simplistic way of looking at it, as there are other factors which contribute as well, but these are the core elements that drive currency values.

Let's take a look at how this works:

Consider a central bank like the US Federal Reserve, if they hike interest rates, this means that commercial banks pay more for money they loan, which is then passed on to the consumer making it more expensive to take out a loan. This makes the currency more expensive and thus takes money out of the pocket of the consumer, leading to less money supply.

Now the higher interest rate does make the currency appealing as it would provide a better return for savings accounts, or government and corporate bonds. This then drives demand for the currency as supply is dwindling, which increases the value of the currency in question.

A rate cut will have the opposite impact and increase supply of the currency as loans become cheaper but savings rates will decline. This will in theory lessen demand and weaken the currency.

The image below provides a graphical illustration of the process from a rate hike perspective, which in theory should lead to a stronger currency.

Inflation is a key feature here, as it plays a crucial role in when a country may decide to hike or cut its interest rate. When a country experiences high levels of inflation, the currency tends to weaken as the purchasing power of consumers diminishes. This in turn also affects the ability and cost for investors and entrepreneurs to do business. The inverse is true when a country experiences lower levels of inflation. The lower level of inflation means consumers can purchase more as the cost of goods and services are cheaper.

This is where it gets tricky, as a low inflation environment tends to encourage spending, which in turn leads to price increases, which then results in the central banks needing to step in and control spending, so inflation does not rise too quickly. The inverse of this is when a country has a high interest rate and low inflation but wishes to stimulate growth and activity. The central bank may choose to cut rates and put more money in consumers' pockets to spend.

These measures thus directly impact the central banks’ decision of when to cut and hike interest rates and cannot be ignored.

The image below shows the relationship between US inflation (red/purple line) and US interest rates (blue line). Historical data shows that each time inflation got above the 2% mark, this is usually followed by a rate hike.

As we have broken down the connectedness of inflation, interest rates and foreign exchange pricing, let’s look at what it means for a currency.

The first thing we need to be mindful of is that currency exchange rates are impacted not just by events such as rate hikes but also by the perception of market participants. At the end of the day, people trade the markets, and their perceptions and feelings cannot be ignored.

What this means is that heading into a central bank meeting where interest rate announcements are expected, market participants are already anticipating a decision in a particular direction. Whether it be a rate cut or hike, as well as the number of basis points.

When announcements about interest rates are made, traders and investors adjust their expectations. This influences how much they want the currency, causing changes in its demand in the currency markets and, thus, its value.

The table below displays the possible scenarios that come from a change in interest rate expectations for the US dollar (in theory):

The question is, how can traders use such information to stay informed and derive a benefit? Well, let's look at the potential opportunities that may arise from such events.

Interest rate differentials simply refer to the difference in the interest rate between two countries. Such a move presents market participants with an opportunity.

If, for example, you expect the UK/Bank of England (BoE) to unexpectedly hike rates, you expect GBP strength. At the same time, the Euro Area/European Central Bank (ECB) are expected to hold rates steady or cut the interest rate, and in theory this could lead to a weaker Euro. It would provide market participants with a possible trade setup on EUR/GBP. Given that the UK is hiking rates while the Euro Area is holding rates/cutting rates, EUR/GBP could, in theory, fall.

The reason this is something to pay attention to in the current economic climate post-COVID is that we are starting to see rate differentials becoming a real possibility. As central banks around the world have largely been on a hiking cycle to reign in the post-COVID inflationary pressures, the cutting cycle we have entered has faced some headwinds in certain countries.

As the US prepares for the return of President Trump, tariff talks have led to dovish repricing of Fed rate cut expectations. This comes at a time when both the ECB and BoE are under pressure to carry out more aggressive rate cuts. The ECB in particular is suffering from sluggish growth. Should such a move materialise in the coming months, it could cause EUR/USD bulls a real headache.

It is important to note that it is not just interest rate decisions that have this impact, but a change in expectations can do this as well. If interest rate futures for the United States are pricing in significantly more rate hikes for next year in comparison to the United Kingdom, we could see US dollar appreciation against the British pound.

Taking a look at potential opportunities that may arise from rate differentials, we have an example on EUR/USD which has developed over the past few months.

EUR/USD had been on a steady move higher since April 2024 as markets began anticipating rate cuts from central banks globally. In September, The Federal Reserve shocked many with a 50 bps rate cut, which came on the heels of a significant jobs data downgrade. This gave market participants a sense that the Fed may cut rates more aggressively than the ECB, and the resulting US Dollar weakness saw EUR/USD reach a high of 1.1200.

The developments since then have, however, been the complete opposite. An excellent Q3 GDP print for the US overshadowed the EU, which is struggling to inspire growth. This was led by poor performance in Germany, which is the Euro Area's most industrialised economy.

The vastly different trajectory of the two economies weighed and sent EUR/USD spiralling to the downside. A brief pullback ensued before the US election last week, before Trump’s victory.

The implications of the victory can be seen on the chart, as EUR/USD continued its move to the downside. This is down to market participants pricing in less rate cuts from the US as they anticipate tariffs might impact US inflation. On the other end of the pond, the Euro Area continues to struggle, which has seen more aggressive rate cuts priced in for the Euro Area, which has left the currency vulnerable against the US Dollar.

Focus will then shift to the implied interest rates for the upcoming period. The implied interest rate is simply the difference between the spot/current interest rate and the futures or forward rate. For example, if the current/spot rate for the US Federal Reserve is 4% (400 bps) and the futures or forward rate in 1 year's time is 3.5% (350 bps) the implied rate will be 3.5% (350 bps) which is 0.5% lower or -50 bps from the current spot rate.

Looking at the implied interest rates of both the Federal Reserve and the ECB through December 2025, and the focus should be on the amount of basis points rates are expected to be cut or hiked for the period ahead. As things stand markets are pricing in around 145 bps of cuts for the ECB. The Federal Reserve on the other hand is expected to cut rates by a cumulative 77 bps over the same period. Given that the ECB is expected to cut rates twice as much as the Federal Reserve over the next year, this should in theory lead to a period of US Dollar strength.

The images below show the implied rates for the ECB and Fed through to December 2025.

Now, as with most trading strategies, it is always better to have more than one form of confirmation before taking a trade. Thus rate differentials on their own are not enough to justify a position, but when coupled with another sign from a technical perspective, the probability of success is much higher.

The use of technicals to confirm a potential entry will also help keep the risk management in check. It will also help that market participants identify a more favourable price for entry. Market participants could use various indicators or techniques for confirmation such as the RSI, price action, candlestick patterns and multi-timeframe analysis.

The chart below with explanatory captions explain the potential setup available as the election results in the US were digested.

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