Interest Rate

Interest rates set by central banks are the single most powerful driver of currency values in the medium to long term. When a central bank raises interest rates, it makes holding that currency more attractive (better returns on deposits and bonds), which increases demand and typically strengthens the currency.

The relationship between interest rates and currency values creates the basis for "carry trades" — borrowing in a low-interest-rate currency and investing in a high-interest-rate currency to pocket the difference. The Japanese yen has historically been a popular funding currency for carry trades due to Japan's persistently low rates.

For forex traders, it's not just the absolute interest rate that matters — it's the differential between two countries' rates and whether rates are expected to change. Markets are forward-looking. A rate hike that everyone expected barely moves the market. A surprise hold when a hike was expected? That can cause a significant selloff. This is why NFP, CPI, and employment data matter: they shape rate expectations.