Euro-Dollar Forecasts are Dropping on "Unprecedented" Central Bank Divergence

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Institutional analysts are revising lower their forecasts for the Euro against the Dollar following a recent reappraisal of where interest rates in the U.S. and Eurozone are headed in the coming months.

With the Federal Reserve unlikely to cut rates as much as the European Central Bank in 2024, the team at Crédit Agricole reckon a fall to parity in the Euro to Dollar exchange rate is now possible on their forecast horizon.

"The precipitous recent drop of EUR/USD has raised questions about the risk of further collapse towards parity in the coming months. We believe that such risks could grow from here," says Valentin Marinov, Head of G10 FX Strategy at Crédit Agricole.

Euro-Dollar has fallen 3.30% in 2024, from 1.1030 to 1.0670, driven by the significant repricing in Federal Reserve rate cut expectations. When we walked into the year the market was expecting 150 basis points of cuts, but a string of hot inflation prints and resilient economic data have whittled that expectation down to just 40 bps.

On the other side of the equation, the ECB is anticipated to cut in June, with the potential of two further cuts being entertained by markets before year-end.

"We and the markets expect the ECB to start easing ahead of the Fed and deliver more aggressive rate cuts this year. If confirmed, this would be an unprecedented development since the creation of the EUR," says Marinov.

He points out that the ECB policy cycle tended to follow the Fed cycle in the last 25 years, but this time around the ECB won't have the cover of the Fed. This could create a significant degree of divergence in interest rate differentials.

Above: The market's expected path for Fed rates. As can be seen, far less cuts are now expected than at the start of the year. Image: Goldman Sachs.

Capital Economics is updating its forecasts to reflect that the Dollar will likely remain on the front foot for a bit longer.

"Notably, we now forecast the EUR/USD rate to fall to 1.05 (previous forecast 1.10) by the end of 2024," says Jonathan Petersen, Senior Markets Economist at Capital Economics.

Euro-Dollar peaked just north of 1.11 in late 2023 following a strong Dollar selloff that followed the Federal Reserve's December policy update, where it communicated the next move would likely be to cut interest rates. The signal prompted a significant easing in financial market conditions.

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But Fed Chair Jerome Powell and his team will rue that premature signalling. This week, he said in Washington that rate cuts are contingent on gaining "greater confidence" that inflation is moving towards the central bank's 2% goal. "The recent data have clearly not given us greater confidence and instead indicate that it is likely to take longer than expected to achieve that confidence".

ABN AMRO is confident the Fed will cut rates by more than markets currently anticipate, albeit from a later starting point. Economists at the Dutch bank expect the Fed to start easing in July (previously June) and to cut rates by a total of 75bp in 2024 (previously 125bp), but to cut more in 2025.

"We have adjusted our forecasts for EUR/USD reflecting the above. Our new forecasts for Q2 and Q3 are 1.05 and for year-end at 1.07. Before, these forecasts stood at 1.10," says Georgette Boele, Senior FX Strategist at ABN AMRO.

The Dollar has also found support from a decline in broader investor confidence linked to global geopolitics, while Chinese authorities have let the renminbi depreciate more than expected. 

"There is scope for a larger rise in the dollar if risk sentiment were to deteriorate more substantially – if, for example, events in the Middle East take another turn for the worse or the Chinese authorities opt to allow a further depreciation of the renminbi," says Petersen.

Above: EUR/USD at 1.05 is an increasingly popular forecast amongst investment bankers. Track EUR/USD with your own custom rate alerts. Set Up Here

But further declines in Euro-Dollar could take some time to materialise as the market is looking stretched following the recent Dollar rally.

"I get the impression that the market is quite comfortable with current levels in EUR-USD and would be reluctant to leave its comfort zone - unless there were really new insights that led to a reassessment of interest rate expectations, for which, however, there will most likely be no triggers this week," says Antje Praefcke, an analyst at Commerzbank.

"In this respect, I assume that the dollar will only lose a little ground - if any - over the next few days and that EUR-USD will remain below the 1.07 mark for the time being," she adds.

Expect a strong decline in the Dollar if the Fed does proceed with a number of rate cuts in the coming months. Analysts at Citibank are not shaken by recent market developments and stick by forecasts for five Fed rate cuts this year, saying policymakers will seize on any signs of disinflation or economic weakness in upcoming data.

"We’ve been thinking about the economy’s trajectory in 2024 very differently from other forecasters," Andrew Hollenhorst, a Citi economist, said in an interview this week. "We think the Fed’s reaction function is a lot more dovish than the consensus."