After the expectation of a rate cut by the Federal Reserve "collapsed", the euro was the one that got hurt

With the divergence in economic performance between Europe and the United States, after the expectation of a rate cut by the Federal Reserve "collapsed", the European Central Bank is expected to cut interest rates more times than the Federal Reserve this year, leading to expectations of the euro falling towards parity with the dollar.

According to media reports on Tuesday, financial institutions such as Bank of America and BNY Mellon are simulating various risk scenarios, warning that if there are differences in the pace of interest rate cuts between the European Central Bank and the Federal Reserve, the euro may face downward pressure. Geoffrey Yu, senior strategist at BNY Mellon, stated:

"It is possible for the euro to reach parity with the dollar this year, and the possibility of the European Central Bank cutting rates on Thursday cannot be ruled out."

However, so far, no strategist has used 1:1 as a benchmark prediction, which means the euro would need to depreciate by about 8% to the level seen during the most severe European energy crisis. Nevertheless, almost no one is prepared to ignore the possibility of this decline. Moritz Kraemer, Chief Economist at LBBW, stated:

"If the Federal Reserve keeps interest rates unchanged while the European Central Bank eases monetary policy, the euro against the dollar will easily fall below parity. By 2025, the euro to dollar exchange rate will drop to 1.01, the most pessimistic forecast among many analysts."

Increasing Divergence in Euro-American Economies Leads to Continued Weakness in the Euro

Currently, the divergence between the Eurozone and the United States is very clear. Last week, US employment data rose significantly, unemployment rate decreased, and a strong labor market drove economic growth. In contrast, inflation in the Eurozone has fallen faster than expected, and economic growth has remained almost unchanged since the European Central Bank began raising interest rates.

This divergence is particularly evident in the currency markets. Despite recent easing expectations for Europe, traders still predict that the European Central Bank will cut rates by about 85 basis points in 2024 to stimulate the economy, while predicting that the Federal Reserve will only cut rates by 65 basis points.

This expectation has already put pressure on the euro, with the euro against the dollar falling by over 1.5% to $1.085 since the beginning of this year.

Since the European Central Bank's policy decision in March, liquidity in the options market indicates that if the euro falls below $1.07, the next target is expected to be $1.05. Approximately 60% of option positions expect the euro to depreciate.

Possibility of Euro/Dollar Falling to Parity?

Strategists at Bank of America evaluated that if the Federal Reserve maintains interest rates unchanged this year while the European Central Bank implements three 25 basis point rate cuts, the euro against the dollar may return to parity. If there is a new energy shock, the euro may fall further.

Samuel Zief, Global Head of Foreign Exchange Strategy at JP Morgan, stated that each additional rate cut by the European Central Bank relative to the Federal Reserve could lead to a 1% decline in the euro to dollar exchange rate.

Economist Adrian, Chief Economic Advisor at Allianz Group, is also monitoring the potential risks in the euro currency. He pointed out that the relative pricing between Europe and the United States has had a significant impact, and parity between the euro and the dollar is a possibility

Will the ECB lay the groundwork for a rate cut tomorrow?

Analysis suggests that ECB officials will lay more groundwork for the first rate cut on June 6th at this week's meeting, despite their strong opposition to following the footsteps of the Fed. They have not yet decided on the policy direction after the initial action, insisting that economic data will guide policy decisions.

While Lagarde and her colleagues will emphasize that they are not influenced by the Fed in terms of interest rate policy, they will tread carefully to avoid causing currency depreciation. Jamie Niven, Senior Portfolio Manager at Candriam, pointed out:

I know they all talk about their independence from each other, but there are clearly links between central banks with different monetary mechanisms. For example, if the Fed cuts rates by 50 basis points and the ECB cuts rates by 100 basis points, I think that would be difficult to achieve