Over the long run, the most powerful driver of a currency is its interest rate, and above all the gap between two countries' rates. Money flows toward higher returns, so when one central bank raises rates relative to another, its currency tends to strengthen.
Rate differentials
Traders watch the difference between two countries' interest rates, and especially how markets expect it to change. A pair like USD/JPY tends to track the gap between US and Japanese bond yields. It isn't the current rate that matters most, but the expected path: a currency often moves when expectations for future rate hikes or cuts change, long before the decision itself.
The carry trade
A carry trade borrows a low-yielding currency and buys a high-yielding one, earning the difference. In spot forex and CFDs, that difference shows up as the daily swap you met in Module 1: holding a long position in the higher-yielding currency usually earns a positive swap (before the broker's markup).
Worked example
Imagine country A pays 4.5% and country B pays 0.5%. You buy A against B, holding the equivalent of $100,000.
The rate gap is 4% a year: about $4,000 a year, or roughly $11 a day, before broker markups, if the exchange rate stays flat.
A 4% fall in the exchange rate would wipe out a full year of carry. That's the risk.
Carry unwinds
Carry trades are popular in calm markets, so many traders end up holding the same positions. When fear rises, they all close at once, and high-yielding currencies can fall very fast. Traders describe it as "up the stairs, down the elevator".
Key takeaways
- Interest-rate differentials, and expectations of how they'll change, drive currencies over the long run.
- A carry trade buys a high-yielding currency against a low-yielding one to earn the rate gap.
- In spot forex and CFDs, carry shows up as the daily swap, minus the broker's markup.
- Carry trades rise slowly and can unwind violently when fear rises.