Christian Zimmermann (@czimm-economist.sciences.social.ap.brid.gy)

The link between interest rates and exchange rates Today’s post explains the relationship between interest rates and exchange rates and how they’re involved in investment decisions. **The data** The FRED graph above tracks two rates: * The solid red line shows the exchange rate between the US dollar and euro. * The dashed blue line shows the difference in interest rates (or yields) between the long-term/10-year US Treasury bond and the German government bond. We can see in the graph that these rates appear to be related: When this interest rate differential (US bond yield minus German bond yield) has increased, the US dollar has tended to appreciate. But exchange rates are affected by many factors, especially shocks that alter market views about the long-run future exchange rate. Such a shock appears to have occurred after April 2, 2025 (a.k.a., “Liberation Day”). The graph shows that, at the time, US Treasury yields rose sharply relative to German government bond yields. In theory, that would have implied a stronger US dollar. But instead, the dollar depreciated. Market participants seem to have revised down their expectations of the dollar’s long-run value, possibly due to concerns that large tariffs would erode US economic fundamentals.* For a deeper look, read on… **Investing decisions** Economists see a tight link between these interest rate differentials across countries and the _expected_ changes in the exchange rates. So, in theory, investing in domestic bonds or foreign bonds _should_ yield roughly the same rate of return. Again, when the interest rate differential (US bond minus German bond) increases, the US dollar tends to appreciate. This pattern supports the validity of the economic concept known as uncovered interest parity, or UIP. UIP states that > Domestic interest rate ≈ Foreign interest rate + Expected depreciation of the foreign currency or > Expected change in the exchange rate ≈ Interest rate difference between the home and foreign countries Bond yields in both the home and foreign countries are known at the time of investment and therefore they involve little uncertainty. But exchange rates are another matter. Investors in foreign bonds must first convert their funds into the foreign currency to buy those foreign bonds. Then they must convert their funds back to the domestic currency once the foreign bond matures. The _future_ exchange rate isn’t known at the time of investment, so the return from investing abroad is uncertain because of that exchange rate risk. **Long-run theory versus short-run observations** These patterns still support the validity of a _long-run_ UIP through a mechanism in which today’s exchange rate adjusts to maintain parity, rather than through a shift in the long-run average exchange rate. But empirical evidence shows that, in the short run, exchange rates are nearly unpredictable and behave close to a random walk. This suggests that UIP doesn’t hold in the short run. The data support UIP much better in the long run. Over longer horizons, exchange rates tend to revert to the mean. When there’s an increase in the interest rate differential between the home and foreign countries, today’s exchange rate should appreciate immediately in the higher-interest-rate country so that the expected exchange rate depreciates in the future as it swings back toward its long-run average. In other words, long-run UIP can hold through an exchange rate adjustment occurring today, rather than through changes in the long-run average exchange rate. Consider this example: Suppose the long-term domestic interest rate remains unchanged at 5%, while the foreign long-term interest rate suddenly falls from 4% to 3%. Long-run UIP implies that investing abroad should still yield roughly a 5% return on average, despite the lower foreign interest rate. The 1- percentage-point reduction in the foreign interest rate should therefore be compensated by an expected appreciation of the foreign currency of about 1% annually. To achieve this, the domestic currency must appreciate immediately, so that it is subsequently expected to depreciate as the exchange rate converges back to its long-run average. *See Jiang et al. (2025). **How this graph was created** : Search FRED for and select the US Dollars to Euro Spot Exchange Rate (DEXUSEU) series. Click on “Edit Graph”: Under the “Edit Line” tab, modify the frequency to monthly and scroll down to the formula box and enter _1/a_. Thus, instead of a USD/EURO exchange rate we have a EURO/USD exchange rate. Next click on “Add Line” and enter DGS10 to add the yield for 10-year US government bonds. Modify the frequency to monthly. Under “Customize data,” add the series IRLTLT01DEM156N, which is the 10-year German government treasury bond yields. Change the formula to _a-b_. From the “Format” tab, under line 1, click customize and change the color to red. Under line 2, click customize and change the color to blue and place the axis on the right. Finally, edit the dates so that the series starts on January 1, 2024. Suggested by YiLi Chien and Kevin Bloodworth. https://fredblog.stlouisfed.org/2026/02/the-link-between-interest-rates-and-exchange-rates/