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The Growing US-EU Monetary Policy Divide

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Yesterday saw important interviews by the heads of the world’s two largest central banks, the Fed’s Jerome Powell, and the ECB’s Christine Lagarde. The interviews were particularly relevant because of the opportunity to press each with regards to the monetary policy outlook. While neither provided any new information that shocked the markets, the comments were really relevant for FX moves.

What stands out is the growing divide across the Atlantic. The BOE’s Andrew Bailey didn’t give an interview in a similar format recently, but it’s notable how the UK’s central bank outlook is closer to the ECB than the Fed. This brings important implications for the future of both cable and fiber, though given the latest developments, we’ll focus on the latter for now.

Who Will Go First?

Up until quite recently, there was a general perception that the ECB and the Fed would start cutting around the same time. This would mean that, at least initially, the interest rate gap between the two economies would remain unchanged. In other words, The monetary policy would be neutralized when it came to the effect on forex. Eventually it was expected that the Fed could cut farther than the ECB, but that would be resolved later in the year, reducing the impact on the EURUSD.

But that trend has shifted substantially, and it was clearly illustrated and articulated by both Powell and Lagarde yesterday. The market is now pricing in the first rate cut from the Fed by September at the earliest. Meanwhile, the ECB is expected to cut rates as soon as June, and for every meeting after that to be “live”. In other words, it’s possible for the gap in interest rates between the two economies to grow by as much as 50bps by the end of the third quarter.

Why it Matters

The difference in interest rates are determinant for money flows between economies that drive the medium- to long-term values of the respective currencies. It was that differential that drove the Euro below parity in late 2022. Investors looking for a better return on their money will prefer to buy bonds in whichever economy offers a higher relative interest rate.

So, if the ECB starts cutting before the Fed, then the interest rate differential will lead to a weaker Euro as investors sell their Euro denominated bonds at a higher value in order to buy dollar bonds that would be expected to rise in price once the Fed starts its own cutting program later. This means that the forces are lining up for the Euro to be weaker through the summer.

What They Said

Why the speeches by Lagarde and Powell are particularly relevant is because the ECB President essentially repeated what she’s been saying all along: That there will be enough information to change policy by the end of May. In other words, the most likely time for a cut will be June. She declined to comment on the market’s expectation of three rate cuts this year

The market is expecting only two cuts from the Fed this year. Meanwhile Powell doubled down on the need to keep rates higher for longer, saying that the restrictive policy needs further time to work. He referenced the latest uptick in headline inflation as a reason to not cut rates. The difference between Powell and Lagarde’s stances essentially underscored how the monetary policy between them is once again diverging, and could keep downward pressure on the EURUSD. And with the BOE in a similar situation as the ECB, so too could cable be under pressure.

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