FX Daily: Policy Convergence Raises EUR/USD Potential
Original article by Chris Turner, Head of FX Strategy at ING (Source: ING Think)
The foreign exchange (FX) market is experiencing a notable recalibration as central banks begin aligning their monetary policy strategies. This synchronization is beginning to shape market expectations about long-term interest rate differentials. The euro, in particular, stands to benefit from this environment, as the shift could provide support for EUR/USD moving forward.
A Changing Monetary Backdrop
The primary driver in current FX market developments is the evolving policy stance of central banks across major economies. The recent shift in global central banks’ tone reflects shared concerns over inflation, growth, and overall economic stability. One standout aspect of this convergence involves the narrowing gap between U.S. and Eurozone interest rates.
Key global central bank developments include:
– The U.S. Federal Reserve has taken a more dovish stance, signaling that peak interest rates may already be behind us. The market is now pricing in multiple rate cuts in 2024.
– The European Central Bank (ECB), too, has adopted a cautious tone. While having already initiated its easing cycle, it’s maintaining a gradualist approach with no signs of an aggressive cutting spree.
– Other central banks, such as the Bank of England and the Swiss National Bank, are following similar cautious, data-dependent paths. This shift toward synchronized moderation in monetary policies is paving the way for stability in currency valuations.
This gradual policy alignment stands in contrast to the last few years, where the Federal Reserve surged ahead with aggressive tightening while peers lagged behind. As this disparity narrows, currencies whose central banks were once at a disadvantage now find tailwinds.
USD Weakness: The Declining Yield Premium
One of the primary forces impacting the U.S. dollar is the decline in its relative yield advantage. For most of the past two years, the Federal Reserve maintained a comfortable lead in interest rates over its peers, particularly the ECB. This made the dollar a favorable choice for carry trades, reinforcing its strength.
Recent developments have eroded that advantage:
– The Fed’s terminal interest rate expectations have come down meaningfully. At its peak, the Fed funds rate was expected to remain high well into 2025. Markets have now priced in a more flexible path, anticipating as many as four quarter-point cuts in 2024.
– U.S. data, particularly on inflation and labor markets, has started to miss expectations. Softening job growth and cooling inflation have led markets to revise rate expectations lower.
– On the other hand, the Eurozone’s comparatively more stable inflation and current account surplus are giving the euro some resilience against broader dollar strength.
With the gap in 2-year bond yields narrowing between the United States and Europe, less juice remains in long-USD positions. Speculators and institutional investors are beginning to unwind positions as this fundamental driver weakens.
EUR/USD: A Gradual Grind Higher
The euro has started to claw back lost ground versus the dollar. Policy convergence is altering the dynamic in favor of EUR/USD, which now has room to climb further, albeit gradually. Several supporting factors weigh into this bullish bias for the euro:
1. Relative Rate Convergence:
– The ECB, while still behind the Fed in absolute rate terms, is no longer expected to cut rates dramatically beyond the Fed.
– Real interest rates (adjusting for inflation expectations) are closer, reducing the incentive for investors to favor dollar-denominated assets over euro ones.
– As inflation ceases to be a major policy differentiator, other elements such as structural balances and economic momentum will gain prominence.
2. Strong Current Account Position:
– The Eurozone continues to maintain a surplus in its current account, unlike the U.S., which carries a persistent deficit. This buffer gives the euro a structural support longer-term.
– The energy import burden has lessened, and renewables are sustaining a higher share of Eurozone energy consumption, reducing vulnerability
Read more on EUR/USD trading.