Interest Rate

Interest rates are set by central banks to manage their economies. Higher rates make a currency more attractive (you earn more interest holding it) but slow the economy (loans are more expensive). Lower rates do the opposite. Currencies tend to strengthen when their central bank is raising rates (or expected to) and weaken when their bank is cutting (or expected to). The key insight is that markets price the EXPECTED rate path, not just the current rate. A central bank can hike 25 basis points and the currency falls — because the market was pricing in 50 basis points. The actual rate move matters less than how it compares to expectations. Rate differentials between two countries drive currency pairs. If the Fed is at 5% and the BoJ is at 0.1%, USD/JPY tends to rise because dollar-holders earn more interest. If the gap narrows (Fed cuts, BoJ hikes), USD/JPY falls.