We’ve talked about rates and central banks in isolation. But the real magic in FX happens when you compare them.
That’s where interest rate differentials come in — and why they’re one of the most powerful forces in currency trading.
1. The Simple Math Behind Rate Differentials
Currencies don’t move in a vacuum. Every FX pair reflects a relative story.
• If the Fed raises rates while the BOJ stays dovish → USD/JPY climbs.
• If the RBA cuts while the Fed holds steady → AUD/USD drops.
👉 Traders care less about absolute rates, more about the spread between two countries’ yields.
2. The Carry Trade in Action
Classic example: AUD/JPY.
• Borrow in JPY (near 0% funding).
• Invest in AUD (historically 4–6%+).
• Pocket the yield spread, plus any FX appreciation.
In calm “risk-on” markets, this strategy drove AUD/JPY higher for years.
But when volatility hits, carry trades unwind violently — JPY strengthens as positions are covered.
3. Tools Pros Use to Track Differentials
• Government Bond Yields: Compare 2-year or 10-year yields across countries.
• Forward Rates / OIS Swaps: Show where markets expect rates to be.
• Fed Funds Futures & OIS spreads: Great for pricing divergence between Fed vs ECB/BOJ.
4. Real Market Story: USD/JPY 2022–2023
• Fed hiked aggressively (U.S. 10Y → 4%+).
• BOJ stayed dovish (10Y JGB capped near 0%).
• Result? USD/JPY surged from ~115 to over 150 in under a year — one of the cleanest rate differential trades in decades.
👉 The differential wasn’t just a side note. It was the trade.
5. The Trading Edge
As an experienced trader, always ask:
• Where’s the biggest rate gap right now?
• Is the gap widening or narrowing?
• Is the differential already priced in, or is the market underestimating it?
That’s where opportunity lives.
Where we’re heading next: Tomorrow we’ll dig into inflation surprises and volatility — because even when traders know the rate differentials, it’s those sudden inflation shocks that create the spikes (and wipeouts) you need to manage.
