How will the US dollar move if ECB and BoC cut rates?

While much market commentary is understandably devoted to the impact of monetary policy on exchange rates, we still believe that much of it is a red herring. This is demonstrated by the fact that the US dollar has traded in such a stable fashion this year in spite of divergence in monetary policy expectations between the Fed and other G10 central banks.

This week we are almost certain to see the ECB cut rates and more than likely to see the Bank of Canada cut rates as well, and yet the dollar is not expected to make any ground against the euro and Canadian dollar. The euro might actually strengthen as the discussion between President Lagarde and journalists at the postmeeting press conference is more likely to focus on the fact that the ECB is unlikely to deliver a follow-up rate cut in July, than the rate reduction that is likely to have been announced for June.

We find it instructive that the Swedish krona has not suffered since the Riksbank cut rates a month ago and that in spite of the clear concerns about currency weakness that were held by the Riksbank. In fact, as Figure 1 shows, the krona has rallied against both the dollar and the euro since rates were reduced. This may be partly down to the fact that rate cuts from the likes of the Riksbank are not leading to significant declines in real rates relative to the US because inflation is falling.

Another point is that 2024 might be the year in which central bank easing kicks into gear for most G10 nations, but it is also a year in which crucial elections occur. And it is the outcome of these elections that could drive currencies more than any rate cuts. The US election on November 5th is undoubtedly the elephant in the room, not just for the currency market, but all assets.

Before then, we will see EU parliamentary elections between June 6th and Jun 9th. These will go under the radar as far as the FX market is concerned, although it is notable that there will be a significant drift to the right in the EU parliament if opinion polls, and the outcome of many recent national parliamentary elections is a decent guide. The UK elections, on the other hand, will see a dramatic shift to the left on July 4th.

A recently-released large opinion poll suggests that the Conservative Party will be wiped out in the election; dropping from 344 seats to just 66, while Labour surges from 202 seats to 476. But while such a huge majority for Labour seemingly allows it to materially change the economic landscape, tight budget finances reduce its scope for manoeuvre considerably.

In addition, this strong poll lead has come at a cost of constricting taxation and spending commitments, further narrowing the room for change. This too helps insulate the pound from any vulnerability that we might have witnessed in the past when the left-leaning Labour Party was thought to be in with a chance of governing. We fully anticipate a strong election victory for Labour, but also expect the outcome to leave Sterling barely moved. In fact, we think it is more likely that the outcome will generate some modest strength for the pound, not weakness.

But whatever happens in the UK/EU elections, or any other non-US elections this year, it is undoubtedly the case that November’s US presidential election will dominate, not least because the outcome is very difficult to call. While the UK election is easy to call but unlikely to lead to a major change in policy, the US election is the polar opposite; difficult to call but with potentially dramatic implications should former president Trump win a second term.

Last week’s criminal conviction of Trump is unlikely to sway confidence in calling the election outcome, and that means the dollar could continue to meander sideways until the day after the election. The first time Trump won, short-term dollar strength was followed by a longer bout of weakness. We’d expect the same sort of profile if he wins a second term with the euro, for instance, sinking into a 1.0-1.05 range before recovering over the long haul to 1.20-plus. Should Biden win a second term, we’d skip the idea that there might be a short-term dollar rally first.