Interest Rate Differentials

An interest rate differential is the spread between one country’s interest rates in a specific tenor and another country’s interest rate in the same tenor. For example, the European and US yield differential in the 2-year space and the 10-year space are reflected in the chart below.

Capital Flows

The red arrows show the yield differential which shows that the US yield is higher than the European yield and is correlated to the movements of the EUR/USD currency pair. Generally the 2-year yield differential is more correlated than the 10-year yield differential because the 2-year yield makes up the borrowing costs of holding the currency pair.