For over a month now, the EURUSD has been trending higher, thanks in large part to a weaker dollar. With both the Fed and the ECB shifting to a holding pattern from a hiking bias, it appears that a new situation is developing. Do the fundamentals point to further upside for the pair, or is this just a correction before it resumes the downward trend since the summer?
One of the issues has to do with the longevity of the recent rate hikes. What drove dollar strength against the Euro in the past was the Fed being more aggressive in its tightening. But, that also means it could be the first to start turning around. Of course the Fed says it will keep rates high for a long time. But the Fed also said that inflation would be transitory.
Getting Ready for Interest Rate Whiplash
The ECB has brought its key rate to 4.5%, which is a whole percentage point lower than the 5.5% for the Fed. The gap in interest rates is generally seen as keeping the Euro below the 1.100 handle for now, because it’s just that much more worthwhile to hold debt in dollars than in Euros.
Higher rates now might mean a stronger dollar, but it also means there is more pressure for the Fed to cut. The higher the rates, the more resistance to economic growth. That means whichever central bank has higher rates will likely face more pressure to cut, if all things are equal. And if cutting is in the cards, then they can cut even more. That means the dollar has more downside, and the conditions for a rate cut would likely be met sooner. Assuming all things being equal.
All Things Are Not Equal
The thing is, the US has seen exceptional economic growth, while the EuroZone is teetering on recession. Just this week, the European Commission cut its economic growth forecast for this year to 0.6%, and sees only 1.2% growth next year. This is slightly below the forecast from The IMF for 0.7% growth this year in the shared economy.
Meanwhile, the US is expected to grow at triple that rate at 2.1% this year. US growth is expected to match that of the European Union next year at 1.2%. The main reason that central banks would contemplate interest rate cuts is if the economy is sluggish, and inflation has come down. At the moment, the Euro Area has seen inflation fall below that of the US (2.9% vs 3.1%), and is expected to see less economic growth in the near term. What that means is that it’s possible that the interest rate gap will shrink, which is generally positive for the EURUSD.
What About Yields?
The high debt levels that the US has incurred recently has led to investors expecting the US treasury to need to seek more money from the markets. That would be seen as pushing up interest rates, particularly in light of the recent auctions which have shown there is dwindling interest. One of the worries is that the amount of free cash in the system has been falling, and will eventually put a strain on the system, causing yields to spike. That would mean the gap between the Euro and the US’s interest rates would widen even more, which would be negative for the EURUSD.
But, that demand for more debt could be offset by increased economic growth. If the economy is vibrant, it means people and businesses are making more money, and therefore paying more taxes. The government wouldn’t need to borrow as much, keeping yields down. If the US does manage a soft landing and keeps growing while the EuroZone does not, then the recent spike in in the EURUSD could end up being short-lived.
