Why does FX trade the difference between two central banks?
Every other asset class has one central bank to worry about. FX always has two, and it trades the gap between them — not the gap in today's rates, which everyone already knows, but the gap in the expected path and, above all, the gap between the expected path and what was already priced.
Priced-in versus surprise
A currency does not rise because a central bank hiked. It rises when the hike, the statement, or the projections imply a higher path than the market had already assumed. This is why a 25 basis point hike can leave a currency weaker: if the market had priced a meaningful chance of 50, the delivered 25 is a dovish outcome.
The corollary is that markets trade the central bank's reaction function — the rule connecting incoming data to future policy — rather than its last decision. That is why an inflation print can move a currency far more violently than a policy meeting: the print changes the expected path, while the meeting often only confirms it.
Divergence, with the arithmetic
Divergence is when two central banks move in opposite directions, or at meaningfully different speeds. It is the cleanest medium-term setup in FX because it widens the differential repeatedly rather than once.
Illustrative: Central Bank A hikes 25bp at each of eight meetings; Central Bank B holds. The differential widens by
8 × 25 = 200 basis points
over the cycle. Every month of that cycle, the carry from Unit 1 grows, and every month the expected path is revised again.
Two documented episodes
2014–2015. The ECB moved toward negative rates and asset purchases while the Federal Reserve wound down its own purchases. EUR/USD fell from roughly 1.39 in May 2014 to roughly 1.05 by March 2015 — about a 25% move in ten months.
2022. The Federal Reserve raised its target range by 425 basis points over the year while the Bank of Japan held its short-term policy rate at −0.10% and continued yield curve control. USD/JPY rose from around 115 in January 2022 to around 152 in October 2022 — roughly a 32% move.
Both are factual accounts of past periods. Neither is a template, and this course does not claim that a given divergence will produce a given move.
Identify the mechanism rather than memorising the episodes: in both cases the expected path diverged for an extended period, and the exchange rate moved by far more than the accumulated interest differential alone would justify. Markets front-run paths.
Where the relationship breaks
- Real rates. If a central bank hikes only because inflation surprised higher, the real rate may not have moved at all.
- Credibility. A hike from a central bank the market does not believe can weaken the currency, because the hike is read as evidence of the problem rather than the cure.
- Risk regimes. When fear dominates, capital moves toward safety regardless of relative rates — the subject of Unit 4.
- Fiscal and political shocks. These can overwhelm the rate channel entirely and quickly.
In the data
The surprise lives in the economic calendar. Below are four Federal Reserve decisions, each with the rate decided, the consensus forecast before it, the previous rate and the minute it was announced (UTC).
The surprise is the decision minus the forecast. For a Fed decision a forecast always exists; for many smaller releases nobody publishes one, and a surprise series built only from events with a forecast silently drops every event nobody forecast.
Try it now
- For each of the four decisions above, write the policy change (the decision minus the previous rate) and the surprise (the decision minus the forecast).
- Find each of those dates on the EUR/USD daily candles below and Measure the size and direction of the move on the day. A decision at 18:00 or 19:00 UTC lands late in the session, so look at the following day as well.
- Did the largest currency move correspond to the largest policy change, or to the largest surprise? Write one sentence explaining what that tells you about "priced in."