An interest rate differential is simply the difference between the interest rates of two currencies. Because money flows toward higher returns, the currency with the higher (or rising) rate tends to appreciate against the one with the lower (or falling) rate, all else equal.
Traders watch the differential not just at today's policy rates but across the expected path. Government bond yields — especially the 2-year — are a clean market proxy, because they embed expectations for the central bank over the coming years.
Yield spreads as a fair-value guide
For many major pairs, the relevant short-term yield spread tracks the exchange rate closely. The US–German 2-year spread, for example, is a widely used reference for EUR/USD, and the US–Japan spread for USD/JPY. When the spread widens in the dollar's favour, the dollar tends to strengthen; when it narrows, the dollar tends to soften.
The relationship is not mechanical or perfect — risk sentiment, positioning, and intervention can override it for stretches — but rate differentials provide the underlying 'gravity' that pairs tend to return to.
The carry connection
Rate differentials also power the carry trade: borrowing a low-yield currency to hold a high-yield one earns the differential as long as the exchange rate is stable. This makes high-differential pairs attractive in calm markets and vulnerable to sharp unwinds when volatility spikes.