Currencies are priced on where rates are going, not where they are
A currency is a claim on a country's money. Hold it and you earn that country's interest rate. So the higher a currency's rate relative to others, the more attractive it is to hold — all else equal.
But "all else equal" is doing heavy lifting. The market prices the expected path of rates, not today's level. This is why a central bank can leave rates unchanged and the currency moves 200 pips.
The mechanism, one step at a time
- A central bank sets the policy rate to hit its mandate — usually inflation near 2%, sometimes employment as well.
- Higher rates make holding that currency more rewarding and borrowing in it more expensive.
- Capital moves toward higher expected returns, adjusted for risk.
- Demand for the currency rises, and the currency rises with it.
The critical word is expected. If a bank is at 5% and everyone is certain it will cut to 3% within a year, the currency trades closer to the 3% world than the 5% one. Today's rate is history; the path is the trade.