The Dollar is being pulled in two directions
The euro/dollar exchange rate has shown little movement recently. What explains this, and is it likely to continue?
For quite some time now, the general market expectation has been that the dollar will weaken. Investors assume that the Fed will cut interest rates several times over the coming quarters, while the ECB is expected to remain on hold.
The expectation of Fed rate cuts is based on weaker growth prospects, particularly because U.S. trade policies and other political uncertainties are weighing heavily on sentiment. As a result, companies remain very cautious with investments (AI investments being an exception) and with hiring. Job creation has therefore remained subdued for some time.
With significantly lower immigration and foreign workers being sent home, labor force growth has stagnated. Since most companies are not yet ready to lay off staff, unemployment has not risen. However, the Fed fears that prolonged uncertainty will keep growth weak and eventually push companies to start cutting jobs, potentially driving the economy into a downward spiral.
All of this plays out against the backdrop of interest rates already at levels that slightly restrain the economy, with monetary policy effects typically feeding through only after several quarters. Understandably, the Fed prefers to err on the side of caution and lower rates.
This outlook, however, directly conflicts with another expectation: that import tariffs will push inflation well above the Fed’s 2% target. Still, with weak growth and rising unemployment risks, such inflationary pressures are likely to prove temporary.
Europe
Turning to the ECB, the picture is different. Europe is facing a tight labor market with rising wages, yet inflation remains subdued. If growth were to accelerate, inflation could easily take off, but for now growth remains too low—largely due to uncertainty around U.S. trade tariffs. As long as this persists, inflation in the eurozone is more likely to fall than to rise, especially if the euro strengthens further.
In theory, this could justify further ECB rate cuts to prevent a potential U.S. slowdown from dragging Europe into recession. But that risk is limited, as Europe is increasingly supported by fiscal stimulus. The expectation is therefore that the ECB will keep rates unchanged for now.
In short: stable rates in Europe, falling rates in the U.S., and thus a weaker dollar outlook. This is reinforced by the fact that Trump’s policies are discouraging foreign investors from allocating capital to the U.S. Still, the dollar has not weakened further in recent weeks. Why not? There are three main reasons:
- For a while, it seemed that U.S. growth was slowing sharply and unemployment would rise. Recent data have contradicted this, raising doubts about how much room the Fed really has to cut rates. Will today’s high inflation really fade on its own?
- In Europe, the opposite has occurred, with growing speculation that the ECB may be forced to cut rates further and sooner than expected.
- France has been hit by a political crisis around reducing its budget deficit.
Will this situation persist? We don’t think so:
- Trump is increasingly tightening his grip on the Fed. Concerns are rising that the central bank will be forced to help finance the U.S. fiscal deficit by keeping rates artificially low. Such inflationary policies are negative for the dollar.
- Large foreign reserve funds have traditionally invested heavily in the U.S., but Trump’s policies are reducing their appetite to do so. This means less demand for dollars (and more demand for gold).
- Policy uncertainty in Washington is likely to remain high. Even with better economic data, we expect the Fed to gradually lower rates toward the neutral level—around 3% compared with the current 4.375%.
- Europe’s economy is only slowly gaining momentum, but fiscal stimulus should soon provide a boost.
- The French political crisis is worrying, but unlikely to spiral out of control.
Of course, unexpected developments could still push the euro/dollar lower. But for now, we maintain our outlook for higher exchange rates.
