How to trade central banks’ divergence in forex markets

Want to know how central bank interest rates shape forex trends? Trading expert Michael Stark breaks down the impact of central bank divergence and how you can use it to spot opportunities in the markets.

Since 2021 and 2022’s rapid rise in inflation, which impacted many countries with notable exceptions, many central banks chose to hike interest rates substantially. These decisions led to the development of divergent policies between banks that increased their rates and those that weren’t faced with the pressing need to tackle inflation, as their policymakers sought to stabilize their economies. These officials chose this route with the intention of protecting each economy from prolonged volatility. This was one of the primary factors behind the yen’s ongoing losses against most major currencies from 2021 to 2024. Divergence isn’t just something position traders study, though. Developing or declining divergence among central banks can significantly impact the value of major currencies, and can give day traders and possibly even scalpers an edge in many cases 

The latest episode of Trading Talks looks into central banks’ divergence: what it is, how it has historically affected some major forex pairs, including the dollar-yen (USDJPY) and euro-dollar (EURUSD) pairs, and some of its limitations. In this article, I’ll cover this phenomenon in more detail, providing examples of how divergence affects forex markets. But before diving in, you can check out the summary and video of the podcast if you haven’t yet.

Divergence and how it develops

The primary task of a central bank is to keep inflation positive, low, and reasonably stable. Most central banks have historically set a target of 2% for inflation, and they are inclined to raise interest rates when inflation is higher and cut them when it’s lower. Let’s consider the typical dollar-yen example.

For a deeper look at Japan’s monetary policy and how it diverges from other major economies, check out Japan’s trade outlook 2025 on Exness Insights.

Inflation in the USA surged in late 2021 and 2022, forcing the Fed to act before the situation spiralled out of control.

In contrast, Japanese inflation started to rise much later than most other major countries and never rose nearly as much.

The strong divergent inflation between the USA and Japan in 2021 and 2022 meant that the Fed and the BoJ took on diverging policies. The Fed had to hike rates sharply to try to control inflation and later bring it down, and it was mostly successful in doing so. By contrast, the BoJ never had a persistent or significant inflation problem, meaning that they never had a strong case to hike rates. The difference in rates reached a peak of 5.35-5.6% in the dollar’s favour in late 2023 and early 2024.

Of course, there’s a lot more to this than I’ve described, but I personally don’t think that you need to have a highly detailed knowledge of theoretical monetary policy to trade forex. Central banks play a significant role as academic publishers of research on monetary policy. One of the most notable is Sweden's central bank, the Sveriges Riksbank, which regularly publishes both practical and theoretical studies. You’re welcome to explore these publications to deepen your knowledge, but it’s not essential if your focus is solely on trading CFDs.

Trade forex with an edge

Experience better-than-market conditions. Try live or demo.

Trade now

Implications of central bank divergence and interest rates in forex

All things being equal, the practical implication of divergence for forex trading is that the major currency with higher rates in each pair will typically strengthen, except in some specific circumstances, which I’ll outline later in this section. These movements often exceed what many traders expected, highlighting the importance of monitoring policy shifts. However, the challenge here is that things are almost never entirely equal, so I think that relying on divergence alone is unacceptably risky.

For the dollar-yen pair, divergence often works like “it should”, meaning that prices typically go up over the longer term when divergence is likely to increase and down when it’s likely to decrease. I’ll look at this classic example in more detail below under the section on historical examples.

On numerous occasions, divergence doesn’t work like “it should.” The obvious examples usually involve countries with high rates facing significant economic problems or crises, notably Argentina and Turkey over the last several years. A less studied example, which is also valid, is South Africa.

South African rates peaked much higher than those of major countries like the USA, but this never had a consistently positive effect on the rand’s performance.

Much like the Fed, the South African Reserve Bank (SARB) tightened rates strongly from early 2022. However, the SARB’s rates started significantly higher and peaked about 4% higher than the Fed's in 2023 and 2024. During the peak of the central banks’ divergence, the dollar-rand (USDZAR) remained volatile but never showed any clear long-term direction. This lack of support from fundamental factors limited any potential recovery in the rand.

Having looked at this example, I think the main reason the rand never gained against the dollar during this high divergence was due to two key factors: direct and indirect problems outside of the SARB's control, as well as general sentiment and risk appetite.

The job market in South Africa never recovered after Covid, with unemployment remaining consistently above 30% since the third quarter of 2020, and is unlikely to go down significantly. This has constrained South Africa’s overall economic growth, further discouraging confidence in the currency. The South African economy also faces structural challenges that make it harder for the SARB to respond effectively. South Africa’s infrastructure, especially power, has faced enormous challenges for years. Combined with these factors, policymakers have had limited room to stimulate sustainable growth. They are also responsible for balancing fiscal constraints with monetary tools, which limits drastic action. HIV/AIDS affects a relatively large minority of the population, limiting overall economic activity. 

While the SARB was successful in controlling inflation on the whole, it can’t do anything about most of the other issues plaguing the country. Equally, the historical performance of South Africa’s economy is much less stable and much more dependent on trade than the USA’s, so traders are naturally more cautious about exposure to the rand.

How central bank divergence affect capital flows

The effect of divergence on capital flows is an extremely broad topic with a large number of considerations, but I think it’s possible to summarise it with reference to the most relevant aspects for traders. One of the main ones is the carry trade: when one currency in a pair (historically, often the US, Australian, or Kiwi dollar) has a higher interest rate than the other (historically, often the yen), traders might buy the first currency to be credited with carries.

In an environment with high rates, capital tends to flow out of stock markets and into bonds, but this phenomenon has various exceptions.  Central banks’ divergence can affect this internationally, for example, money tends to flow into American treasuries when rates rise or are likely to rise, but I think this also has major caveats: 

1. Most governmental bonds are less accessible to the wider market and more heavily regulated for the end investor or trader than shares or company bonds.
2. The rating is important: Bonds from countries with a reputation for stability are generally viewed more positively. For example, even if they offer higher yields, Argentine bonds are typically rated lower than German ones, so many investors avoid buying the former.

These outcomes often diverge from what many expected, especially during periods of central bank divergence. 

In my personal opinion, it’s pointless in most cases to try to link overall national flows of capital with ideas for trading:

Japanese capital flows generally increased, although with little consistency, as the yen declined strongly in 2023 and 2024.

For example, Japan’s average capital flows have increased since 2022, while the yen has experienced strong losses against most major currencies over the same period. This is despite Japanese rates remaining divergently low relative to almost all other countries. I do occasionally monitor capital flows for major countries, but I haven’t yet found a reliable correlation between them and currencies’ performance. Still, I include capital flow data in my analysis to understand broader market sentiment.

In April 2025, the USA recorded a net negative capital flow of only about 14.6 billion USD, but it seemed obvious from markets’ behaviour that relevant capital was moving much more strongly from American assets into European, Chinese, and several others without regard for monetary divergence. Equally, in the fourth quarter of 2022, following Liz Truss’ disastrous mini budget, I never needed to wait for a chart of British capital flows in the fourth quarter of 2022 to know that they’d be negative or that the pound would decline across the board regardless of the BoE’s divergence with the BoJ. These were self-evident to me under the circumstances.

I want to be very clear here that this is just my opinion. If you have a reliable way to find signals from national capital flows, that’s fantastic: keep doing what works for you.

For more on how fundamental analysis and market sentiment interact with central bank decisions, see Trading fundamental analysis vs market sentiment on Exness Insights.

Historical examples of trades based on divergence

I think the dollar-yen remains the most relevant example of a divergence-based trade in recent years:

A snapshot of the weekly dollar-yen chart. The main long-term uptrend from early 2022 still hasn’t clearly ended.

As noted above, when it became clear that a large and lasting divergence would develop between the Fed and the BoJ, the uptrend quickly gained strength and extended further than many traders expected in the first half of 2022. This ultimately led to prices reaching a high of nearly 40 years in summer 2024, highlighting the possibility of price moves outpacing fundamental projections. The basic approach to trading divergence was clear for swing traders, but I think there were also opportunities for day traders on various occasions, especially around the Fed’s meetings.

However, in 2025, the euro-dollar pair seems to be a clear example of the opposite. In the case of this pair, divergence doesn’t affect the price in the way one might expect.

The euro-dollar was in a strong uptrend for most of the first half of 2025 despite the ECB cutting repeatedly while the Fed held rates.

The European Central Bank (ECB) made four cuts to its main rates in the first half of 2025, while the Fed remained steadfast at 4.25-4.5%. Based on that alone, the euro-dollar pair should’ve declined. Surprisingly, it reacted in the opposite direction, due primarily to economic and political factors. However, policymakers within the European Union signaled strong support for fiscal flexibility despite potential risks to long-term growth.

Donald Trump’s inauguration as president of the USA prompted various European governments to pledge greater military support for Ukraine, even if it meant breaching fiscal rules.  This decision led to a general improvement in sentiment for  European instruments. Then, in April 2025, most market participants lost confidence in the American government after President Trump announced sweeping new tariffs on most countries, triggering major losses for the dollar. Divergence is very important, but other factors can play more significant roles.

Take control of your FX trading costs

See how much you can save on every forex trade with better-than-market conditions.

Try free demo

Final thoughts: Practical use of divergence

Usually, position traders are most likely to study central banks’ divergence and use it actively in deciding what and how to trade. This works by monitoring inflation in different countries and their central banks’ reactions to it. You should also track growth trends and manage potential risks that arise from shifting interest rates. However, I think that day traders also have opportunities to trade any changes in divergence if they can analyse and enter quickly while still managing risk.

With Exness, the choice is yours. If you want to hold a long-term position, you can do that, but you can also day trade with the same excellent spreads and execution. These spreads are designed to remain consistent, even during volatile market conditions, which benefits active traders. This level of consistency offers additional support for active trading strategies. Exness’ spreads for major forex pairs are stable 90% of the time and are, on average, lower than all major competitors.

With Exness, you can enter the forex market and start trading with low, stable spreads and fast execution—check out our forex trading page to explore platform conditions and available currency pairs.

Understanding central bank interest rates and divergence is crucial for forex traders. Whether you’re trading long-term trends or short-term moves, monitoring central bank divergence can give you a real edge. Traders should also determine whether divergence aligns with broader macroeconomic trends before committing capital. Positioning yourself ahead of expected policy moves by the Federal Reserve or the European Central Bank can significantly improve your results.

Frequently asked questions

What is central bank divergence in forex?

Central bank divergence occurs when major central banks follow different economic policy paths, particularly those regarding central bank interest rates. For example, if the Federal Reserve raises rates while the European Central Bank holds or cuts them, it creates an expected divergence that can impact global markets and influence prices and overall market growth expectations. Traders and investors often make decisions based on these policy differences because they can influence currency strength, growth forecasts, and potential risk factors in markets. Understanding divergence helps identify trading opportunities and anticipate possible risks tied to shifting monetary policies.

How do central bank interest rates affect currency pairs?

Changes in central bank interest rates directly influence currency value because higher rates typically attract more capital. For instance, if the Federal Reserve raises its interest rate, the US dollar often strengthens as investors seek better returns. However, this relationship can be complicated by inflation, growth forecasts, and other risk factors in global markets and can directly affect forex prices across pairs. When trading forex, it’s important to focus on how these elements interact and assess whether the expected changes align with broader economic policy trends among major central banks.

Is divergence trading suitable for day traders?

Yes, divergence trading can be suitable for day traders, but it requires careful monitoring of central bank divergence, inflation, and growth forecasts. While long-term traders often base their strategies on major policy shifts, short-term traders can benefit by anticipating immediate market reactions to interest rate decisions, statements from central banks, or updated economic policy outlooks. The key is to manage risks effectively and maintain a strong focus on how markets respond to news in real-time.