In October 2023, the US published figures showing that their inflation was dropping, and moving faster than anticipated in the direction of their 2% inflation target. As a result, we saw a year-end strong rally in the bond market, leading it to predict the Fed would start cutting interest rates in 2024, as early as March.
Meanwhile, the inflationary figures in Europe were not as rosy, leading the central banks to remain more hawkish, at least for the time being.
Early January 2024, the US market was pricing a 70% chance that the Fed would cut rates in March.This this lead to the weakening of the USD against the EUR and GBP as the interest rates difference would not be as large as previously forecasted. With the Eurozone still facing higher than expected inflationary pressures, the ECB was in no hurry to cut interest rates.
On 16 January, Christopher Waller, a Federal Reserve Governor, made a speech highlighting that the Fed is more or less done with hiking rates if the inflation doesn’t rebound. But he sees no reason to cut rates as quickly as in the past. Their decision will depend on the data, and they are expecting closer to 3 rate cuts in 2024, which is a more conservative outlook than the one shared by investors, who are expecting six cuts with the first one starting in March. Rate cuts will happen only when the Fed is confident inflation is moving back to their 2% target. As a result, the bond market has lowered the probability of a rate cut happening in March from 70% to 50%.
What are the implications?
Although the market had priced in a recession in the US in 2024, or at least a soft landing. The economic numbers continue to support continued growth in the US. On the other hand, the economic situation is quite different in Europe, with Germany in clear recession, and many other countries in the Eurozone that are not performing very well. This poor economic performance could lead the ECB to cut interest rates before the US.
If the market starts to believe this, considering the Eurozone has currently lower interest rates, lower growth; there’s a high probability we could see the EUR weaken against the USD.
In our worst case scenario, EURUSD could reach a low of 0.90, a level last seen in 2003. This is a big drop from the current level of 1.085.
Time will be the judge.