EUR/USD Expected to Continue its Descent to 1.05 as Divergence Between the Fed and ECB Persists

In recent times, the landscape of the global economy has seen a notable shift, particularly in the United States and the Eurozone. The US economy, despite its resilience, has encountered a persistent challenge in the form of inflation, prompting investors to recalibrate their expectations regarding Federal Reserve rate cuts. Conversely, the Eurozone presents a picture of comparatively subdued growth and inflation prospects.

USA Past Releases Inflation 

This dynamic has reignited the significance of monetary policy divergence as a pivotal factor influencing the EUR/USD market dynamics. Presently, the rates markets in the US and the Eurozone portray divergent expectations. While US rates markets anticipate approximately 42 basis points of easing from the Fed, with the first-rate cut anticipated in September, Eurozone rates markets forecast a more substantial easing of around 82 basis points from the European Central Bank (ECB), with the first-rate cut anticipated in June.

In my view, I foresee the Fed initiating easing measures in after the second quarter of this year, with a total of two rate cuts or only one, expected by the end of 2024. Similarly, the ECB to commence rate cuts in June, with a total of 2 rate cuts projected for the year. Despite the convergence of my outlook with the prevailing rates market sentiment, we maintain a cautious stance on EUR/USD, foreseeing a heightened risk of the pair testing parity in the coming months.

Several factors underpin my bearish outlook on EUR/USD:

1. Unprecedented ECB-Fed Divergence: Should my projections materialize; the ECB would embark on rate cuts earlier and with more vigour compared to the Fed. Such a scenario, unprecedented in the last twenty-five years, would likely thrust EUR/USD into uncharted territory. Historical analysis suggests that previous instances of the Eurozone central bank easing ahead of the Fed, such as the Bundesbank's cut in March 1995, resulted in depreciation of the Deutsche Mark against the USD.
2. Prospects of Aggressive ECB Quantitative Tightening (QT): Anticipated aggressive ECB QT from current levels may lead to a widening of the EGB peripheral yield spread to Bunds. Given the negative correlation between this sovereign credit risk gauge and EUR/USD, a widening spread could exert additional headwinds on the currency pair.
3. Monetary Policy Divergence as the Primary Driver: I consider the looming monetary policy divergence to be the foremost negative factor for EUR/USD in the coming months. Further downside risks could materialize if comparisons between the present situation and the US no-landing scenario in 1995 persist. This could prompt investors to further revise downward their expectations of rate cuts, thereby bolstering the USD.

EURUSD 4H Chart 

Considering historical precedents and recent geopolitical events, such as the 2016 and 2020 US elections and tariff announcements made by the Trump administration, EUR/USD has exhibited a tendency to underperform. These observations underscore the potential for continued volatility and downside pressure on the currency pair in the foreseeable future.

Insights Inspired by Credit Agricole (JPY Buying Time): Credit to Their Analysis for Shaping Some Aspects of This Text

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