There is an unusual situation brewing in the currency markets for 2025, with the Euro potentially being one of the protagonists. Depending on how the economic data in Britain evolves, the pound could also be involved as well. Other notable currencies include the Canadian and New Zealand dollars.
The key issue is how these currencies will relate to the US dollar as each central bank plots its own monetary policy course. While there are individual situations with each of the mentioned currencies, the Euro is the most notable being the largest economy and the most actively traded. So, we’ll focus on that pair, as the situation for the other currencies is similar, since the main component is the Fed’s interest rate policy compared to other countries.
Antecedents for the Trend
The rise of interest rates in the post-pandemic period to fight inflation brought back the carry trade, a significant feature of the currency markets. That is where traders take advantage of large differences in the interest rates of two economies to borrow in one at a low rate and lend in another at a higher rate. Japan kept its ultra-low rates in place while other countries, most notably the US, raised rates enough to ignite the carry trade. As a result, the value of the yen plummeted to the point that the Japanese government had to step in on several occasions to prevent the slide.
Looking at the yen, we can see how much of an impact carry trade can have on the relative price of a currency. Minor fluctuations in interest rates generate minor moves in the forex pair. But, if the gap widens enough, then it can precipitate a strong move as investors pile into the currency to take advantage of the momentum and interest rate gap.
The Set Up for 2025
The theme of 2024 has been getting inflation under control, and central banks moving towards easing. Just like not all central banks were even in hiking, they haven’t been even in easing. If they keep more or less abreast of each other, then there isn’t a major interest rate gap for carry traders to exploit.
So far, the BOE, Fed, ECB all started cutting rates in the latter half of the year, some with more aggressive cutting (like the Fed’s 100 bps in total) while others have been more hesitant (like the BOE’s 50bps in total). The thought is that the general trend will continue, leaving not all that much room for carry traders to exploit.
The Opening for the Move
However, markets already got a surprise last week when the Fed said it wouldn’t ease as much next year as the market had been expecting. Indeed, if the US economy picks up, that would generate organic inflationary pressure. Add the impact of tariffs on top of that, and the Fed not only might have to forego further cutting, it might have to move back to raising rates.
Meanwhile, the Euro Area is facing a significant slowdown which could be exacerbated if it doesn’t handle the tariffs issue properly. If that were to tip into something closer to a recession, even if inflation is high for non organic reasons (such as geopolitics keeping energy prices elevated), the ECB might be forced to cut more aggressively. (Canada and New Zealand also face slowing economies.) If the gap widens enough, it could entice carry traders to jump in and really push the currency pair over a matter of months.
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