How will the ECB’s policy easing impact the USD dollar?

The fed funds futures market is currently priced for the Fed to deliver 134-bps of rate cuts between now and the meeting in September 2025. The overnight interest swap market says that the ECB will cut by 142-bps through to its September 2025 meeting. That’s just an 8-bps difference. But could the rate-cutting cycle between these two banks be so close?

Steve Barrow, Head of Standard Bank G10 Strategy, thinks it very unlikely. In short, the risk is that the gap widens significantly, either because the Fed cuts by less than anticipated, the ECB by more, or both. What’s more, this is still Steve Barrow’s view even though he acknowledges that the market prices are proportionately more easing from the ECB given that the policy rate in the euro zone starts off some 150-bps below that of the US.

Starting with the US, we can’t help but say that we are a bit unnerved by what the Fed is doing. The 50-bps rate cut to start the easing cycle was a shock, as we only expected a 25-bps reduction. If nothing else, it leaves the Fed in a potentially awkward position for, after justifying the large rate cut at the September meeting, the Fed might have to start justifying a more cautious approach in future meetings, especially if last Friday’s payroll data is a harbinger of more robust data.

We felt at the time that a 50-bps cut was hard to justify given inflation being above target while the economy is still at full employment and with scant signs that higher rates have tightened broader financial conditions materially. This being said, Steve Barrow doubts that the Fed will be easily swayed at this stage. It is likely to want to push on with rate cuts, albeit at a more modest 25-bps pace unless data suggests otherwise. The problem is that it is hard to see the data giving the Fed a great deal of scope to really push the easing cycle on.

Could it be like the 2015-2018 tightening cycle when the Fed hiked the first time in December 2015 but delayed and delayed the next hike until December 2016? Steve Barrow rather doubts that the easing cycle will stall after one cut, but he thinks the risk is skewed towards the Fed delivering less accommodation than that priced into the market than more.

For the ECB, the risks seem to be that the bank will have to deliver more, not less, than currently priced. Indeed, we’ve already seen a hint of this as the Bank seems to have accepted that it will have to cut rates another 25-bps this month; something that ECB President Lagarde did not seem to anticipate at the time of the September meeting. The ECB might have started to cut rates before the Fed but there is a paucity to the euro zone’s economic growth that is just not there in the US. Euro zone data seems more likely to surprise on the downside, while the risks in the US seem to lie to the upside. This also applies to price data in Steve Barrow’s view and, if that’s the case, it opens up the prospect that the ECB will cut by at least as much as that implied in the OIS curve, if not more.

There are numerous ways to play this view in the money market and the bond market. But what about FX? Does the possibility of spread widening between US policy rate expectations and those in the euro zone imply a weaker euro? It might, but a lot depends on context. For instance, if the Fed keeps rates high because it has clearly made a policy mistake then the dollar might not rise as inflation expectations could increase and so lower real rates. Steve Barrow’s sense is that if the Fed does pause the cycle it will be because it made a misstep with the large September rate cut and, for this reason, we are not necessarily anticipating longer-term dollar strength even if the rate spread with the euro zone widens out.