Why currencies can fall after rate hikes and rise after cuts

Novice traders often think a currency will gain following a rate increase and decline after a rate decrease. In practice, markets respond based on how the central bank's move matches or differs from prior expectations.

The latest Reserve Bank of New Zealand (RBNZ) monetary policy decision illustrates this well. Despite an interest rate hike, the New Zealand dollar fell. Many beginners were caught off guard, having concentrated solely on the rate increase.

But the hike had been fully priced in by markets. The New Zealand dollar weakened because the accompanying statement used less hawkish wording and the OCR projections stayed the same. Compared with what traders anticipated, the decision was more dovish overall.

Preparing for the announcement

Ahead of trading a central bank decision, a trader needs to establish what the market has already priced in. This involves examining interest rate expectations using short-term rate futures and overnight index swaps (OIS). These instruments are shaped by economic releases, remarks from central bank officials, and global macroeconomic developments that impact the economy. Additionally, reviewing previews from leading investment banks and research firms online helps capture the consensus. The critical question is not "What will the central bank do?" but "What does the market already expect the central bank to do?"

Reviewing the previous decision

Prior to the announcement, traders ought to thoroughly examine the earlier policy statement and macroeconomic projections. Market participants compare the latest communication with the prior one to spot alterations in wording and economic forecasts.

Minor shifts in phrasing can alter market expectations. For instance, in July the RBNZ stated that "future OCR decisions will depend on how incoming data, price-setting behaviour, and the strength of economic activity affect medium-term inflation pressures". In contrast, today they shifted to "future policy decisions will depend on the Committee’s judgement of the balance of risks to medium-term inflation". The earlier version emphasised data, while the later one highlights the Bank's assessment of risk balance. That change is distinctly less hawkish.

Additionally, the meeting minutes from July noted that "the Committee agreed that while further OCR increases appear likely at upcoming meetings, their timing is highly uncertain". Today's minutes stated "future policy will depend on the Committee’s judgement of the balance of risks to medium-term inflation. This approach allows the Committee to observe and assess the effects of reduced monetary stimulus". This suggests a diminished appetite for tightening.

Concentrating on deviations

Upon release, markets respond to discrepancies between actual outcomes and expectations, not to the rate decision per se. For instance, when the market has priced in three rate increases this year, but the central bank indicates fewer increases ahead, the currency declines. If traders anticipate no policy shift but officials signal possible tightening, the currency appreciates. Should the market project three rate cuts next year and the central bank's outlook shows just one, the response tends to be hawkish. The concept is straightforward. The main point is to assess the announcement against what was already discounted by traders.

The statement revealed clear deviations, and there was also a divergence in the future rate outlook. Specifically, the market had priced in 110 basis points of tightening by end-2027, with an implied rate of 3.60%. However, the RBNZ left its OCR projection for 2027 unchanged at 3.15%. This is considerably less hawkish than what the market had expected.

In conclusion

That explains why currencies can weaken after a rate increase or strengthen after a rate cut. The market perpetually weighs new data against prior expectations. Trade revolves around expectations and surprises. The wider the difference between what was anticipated and what occurs, the bigger the likely market move as traders adjust their positions.