Will the ECB’s more aggressive action endanger the euro?

That will be the seventh 25-bps cut in a row and take the deposit rate 200-bps below the 4% peak that we saw through the latter stages of 2023 and the first half of 2024. The Fed has cut by half as much as the ECB, so rates here are a more modest 100-bps below the recent peak. With no Fed cut in sight, does the ECB’s more aggressive action endanger the euro? It does not seem to have done so thus far, and we doubt that this will change going forward.

Why don’t we see the euro folding under the weight of the ECB’s more aggressive monetary easing? Steven Barrow, Head of Standard Bank G10 Strategy, said there would be a number of reasons.

The first, and most obvious one is that the market is fully priced for the ECB to cut rates by 25-bps this Thursday. Beyond that, the market has at least one more rate cut priced into the curve, but we already know that some at the ECB are pleading for the Bank to at least take a pause here.

This brings us on to the second point, which is that the ECB will presumably pause at some point, or at least signal that it might have cut rates enough. Such a signal will not come as early as Thursday in Steven Barrow’s view, but it will come at some point and, when it does, the euro could rally hard.

In contrast, if the Fed is, indeed, going to resume cutting rates again, as the market suspects, the signal we are waiting for from the likes of FED Chairman Powell is that the bank is ready to ease again – and that could be very bearish for the dollar. In fact, we suspect that the point of peak dollar bearishness on the policy front will come when (or if) US economic data starts to fold and the market anticipates that the Fed will have to shift to an easier policy setting. That ‘folding’ of economic data could come as soon as the payrolls report this Friday.

In sum, while it might seem odd in some ways to argue that the current situation, which sees the ECB easing and the Fed stuck on hold, is bullish for the euro, we only have to remember that the market reacts the most to what is likely to happen in the future; not what’s happening now.

A third point that supports a stronger euro, despite a likely rate cut from the ECB, is that the true value of an asset, like the euro, is not just a function of the return (interest rates) but also the risk and, in our view, the ‘risks’ to the euro have gone down while those for the dollar have gone up.

For instance, if we take higher inflation as a risk, or a negative factor for a currency, then it is clearly the US that faces the biggest risk given tariffs. Hence real (inflation-adjusted) rates look a lot better for euro/dollar than nominal rate differentials.

There are also other risks around the dollar in Steven Barrow’s view. Here we would include things like the sharp rise in US CDS prices and the rising US term premium. This brings us on to a fourth factor, which is currency policy. For while there is much speculation that the US Administration is surreptitiously seeking a weaker US dollar, to help with its trade imbalance, ECB President Lagarde talks about the opportunity the euro zone has to steal some of the dollar’s dominance. Now this does not automatically equate to a strong euro but few would disagree with the statement that safe asset currencies need to be relatively strong, or at least stable.

The euro has been strong in trade-weighted terms, but not against the dollar. If this can be corrected, Lagarde’s wishes could come true. This point runs into the fifth argument Steven Barrow would make which is that the Fed faces unwelcome political interference, while the ECB does not. Of course, the Fed has been here before, when Trump was last president. But we have noted before that the US dollar declined moderately during Trump’s first term in contrast to the strength we saw during Obama’s presidency before Trump, and Biden’s afterwards. Trump’s attacks on the Fed back then might be part of the reason for this and could disadvantage the US dollar relative to the euro again this time.  

The last point Steven Barrow would make is that, in actual fact, rate policy does not really mean very much to the currency markets at the moment as all the focus is on tariffs and, as long as this issue is seen as a drag on the dollar, the greenback is likely to fall against the euro however much the ECB cuts rates.