Why central bank divergence moves currencies

The mechanism

An exchange rate is the relative price of two currencies, so it responds to relative conditions. One of the most important is the return available on each. If interest rates in the US are expected to be higher than in Japan, holding dollars earns more than holding yen, and global capital has a reason to favour the dollar.

That flow shows up in several ways: investors choosing where to hold bonds and deposits, companies deciding where to keep cash, and traders running carry trades, which borrow in low-yielding currencies to hold higher-yielding ones. When the gap between two countries' interest rate paths widens, the higher-yielding currency tends to strengthen.

Expectations, not levels

Markets do not wait for central banks to act. Interest rate futures and overnight index swaps price the expected path of policy rates over the coming months and years, and two-year government bond yields are a widely used summary of those expectations.

What moves currencies is a change in the expected gap. If a central bank raises rates exactly as expected, the currency may barely react, because that move was already in the price. If new inflation or employment data persuades markets that one central bank will tighten faster than another, the currency can move immediately, months before any decision.

That is why analysts track the spread between two-year yields in each pair. When the spread and the exchange rate move together, the rate story is in charge. When they separate, something else is driving the market.

2022: divergence in action

2022 offered a textbook case. The Federal Reserve began raising rates in March and lifted its target range from near zero to 4.25–4.50% by December. The Bank of Japan kept its policy rate at −0.1% and continued to cap longer-term bond yields.

The gap between US and Japanese rates widened sharply, and USD/JPY rose from around 115 in January to above 150 in October, taking the yen to its weakest level against the dollar since 1990. Japanese authorities intervened in the currency market in September and October to slow the fall. The European Central Bank started raising rates later than the Fed, in July, and EUR/USD fell below parity in the same year.

When divergence isn't enough

Higher yields do not always mean a stronger currency. What matters is why yields are rising.

In late September 2022, UK government bond yields jumped after an unfunded fiscal package was announced. On the simple rate-differential view, sterling should have strengthened. Instead it fell to a record low of around 1.035 against the dollar, because investors were demanding a higher risk premium for holding UK assets rather than pricing in stronger growth. Credibility, not carry, was driving the market.

Other forces can dominate too:

• Risk sentiment. In periods of stress, investors often buy the dollar, yen and Swiss franc regardless of interest rates.
• Terms of trade. Commodity exporters' currencies, such as the Australian dollar, Canadian dollar and Norwegian krone, respond strongly to the prices of what they sell.
• Real rates. A high nominal rate alongside higher inflation may offer a lower real return than a modest rate with low inflation.

What we watch

• Central bank communication and projections, and how they change from meeting to meeting
• Market-implied rate paths and two-year yield spreads for each major pair
• Inflation and labour market data relative to expectations
• Real interest rates, not just nominal ones
• Positioning, which shows how crowded a theme has become and how sharply it could reverse

What it means for your exposures

Divergence themes can persist for months, but they tend to reverse when the policy cycle turns, and reversals can be abrupt because many investors are positioned the same way. It is rarely wise to base a hedging decision on the assumption that a trend will continue.

Divergence also affects the cost of hedging directly. The interest rate gap sets the forward points, so hedging out of a high-yielding currency costs more, and hedging into one pays. Understanding the rate outlook is part of understanding the true cost of any hedge.