Rate differential: definition

The gap that sets the price

A currency pair pits two economies against each other. The rate differential is the gap between their yields: for example the US two-year yield minus the German two-year yield for EUR/USD. When this gap widens in the dollar's favour, holding money in dollars becomes relatively more rewarding, and the pair tends to fall.

Which rate to use

Today's policy rate is already known to all. Traders prefer rates that include expectations: the two-year yield, very sensitive to expected monetary policy, or one- or two-year OIS rates, which isolate it even better.

For pairs with more “safe haven” behaviour, such as USD/JPY, ten-year yields sometimes give a better reading, because they also capture long-term investors' flows.

When the relationship breaks

The differential explains a large part of trends, not all of them. In a crisis, demand for the dollar as a safe haven can outweigh the yield gap. And an FX intervention, like Japan's to support the yen, can cause a sharp disconnect for a few days.

When the price drifts away from what the differential suggests for a long time, it pays to look for the other factor rather than bet on a mechanical return.

Frequently asked questions

Is the rate differential enough to forecast a currency?

No. It is one of the most solid medium-term drivers, but risk, capital flows, the current account and interventions also matter.

What's the link with the carry trade?

The carry trade is precisely about collecting this differential: borrowing in the low-rate currency and investing in the high-rate one.