Strong Euro-Dollar Rebound Forecast by DNB

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Divergence in the performance of Eurozone and U.S. economies is about to swing in favour of the Euro, according to new research from DNB Bank, which predicts a consumer-led recovery is about to take hold in Europe.

At the same time, U.S. outperformance will fade as higher interest rates contribute to a loosening labour market, inviting up to 100 basis points of interest rate cuts from the Federal Reserve in 2024.

"We believe in a recovery in the eurozone economy, which should lead to rising EUR interest rates relative to USD interest rates and thereby support a recovery in the euro in the coming year as well," says Ingvild Borgen, Senior Economist at DNB's Markets division.

New research from the Scandinavian lender finds the Eurozone's labour market will remain strong due to structural reasons and support earnings as inflation continues to fall, boosting growth and ensuring it will be many months before the European Central Bank (ECB) will be in a position to cut interest rates.

"The outlook for continued elevated wage growth, in combination with falling headline inflation, will lead to a further rebound in households' disposable incomes," says Borgen.

The predictions come amidst a period of low investor confidence regarding the Eurozone's outlook owing to months of disappointing economic performance, much of it centred on Germany's flagging industrial base.

But the bloc's services sector and consumer-facing industries have tended to perform better, and it is here that a Eurozone recovery will likely accelerate, according to DNB's research.

Above: Low Eurozone unemployment should support wages as inflation comes down. This can keep ECB rate cuts at bay, supporting the Euro, according to DNB Markets.

"We do not believe the recent weakness in eurozone data should be seen as a token that growth overall is set to be weak going forward. On the contrary, the stagnation of the eurozone economy during the past year is driven, in our view, by the purchasing power crisis among eurozone households, and this is about to turn," says Borgen.

Q2 marked the first quarter when disposable incomes grew more than inflation, and DNB believes this will continue.

Above: Real incomes in the Eurozone are starting to recover, and this can continue, says DNB.

The U.S. economy has meanwhile outperformed on a relative basis, leading to higher U.S. interest rate yields and Dollar strength.

"We expect the US economy to show increasing signs of weakness and that the unemployment rate will continue to rise. This is also a key reason why we expect the Fed to cut interest rates as soon as June next year, and that the upper bound for the Fed Funds Target Rate will be 3.75% by March 2025," says Borgen.

Above: The difference between Eurozone and U.S. interest rates will fall, boosting the Euro, says DNB.

This is below the market's current expectations of 4.0% at the same time.

The ECB is meanwhile only expected to cut rates as late as September next year, "and if anything, later".

All this means DNB anticipates the spread between the Fed and the ECB’s policy rates to fall from approximately 1.5 percentage points now to 0.5 percentage points in early 2025, a development that can support the Euro against the Dollar.

"The spread between 2-year US and German government bond yields tracks the Fed-ECB policy rate spread quite closely," says Borgen.

"A drop in USD-EUR interest rate spreads is thus the main reason we expect EURUSD to rise going forward, and we therefore do not see any fundamental reasons to change our current forecast, which is for EURUSD to rise to 1.15 in three months and 1.20 in 12 months," she adds.