A Delayed Dollar Downtrend: Evaluating the Medium-Term Outlook for EUR/USD

We had previously pointed at the third quarter of 2023 as the period where the dollar would decisively turn lower. Recent developments in US data and Fed communication may well have delayed the big chunk of the USD decline, but medium-term valuation and our expectations for Fed rate cuts in early 2024 mean EUR/USD can still eye 1.15 around the turn of the year.

 

A prolonged pause in the dollar decline

In previous rounds of forecasting, we had pointed to the third quarter of this year as the period where a dollar downtrend could truly materialise, as the combined evidence of slowing inflation and the economic slowdown would lead the Federal Reserve to a dovish turn. Now in July, we have to acknowledge that it may still be too early for the dollar to take a decisive and sustainable turn lower this summer.

The recent strengthening in FX with short-term rate correlations means central bank divergence remains generally the predominant driver across USD crosses, and the dollar outlook is likely to remain strictly tied to Fed rate expectations. Our rates team believes a drop in short-term USD rates now looks more likely to be a fourth-quarter and early-2024 story, which means EUR/USD could mostly bounce around the 1.08-1.10 range this summer, without a very clear sense of direction, before taking a decisive turn higher to 1.15 by year-end.

The ECB’s hawkishness, underpinned by sticky core inflation in the eurozone, can help keep front-end EUR swap rates supported, and offer more support to the euro, but is also unlikely to do the heavy lifting in a longer-lasting EUR/USD bull trend. We expect two ECB hikes, in July and September, and only a gradual abatement of the hawkish rhetoric. Markets however are fully pricing this in, and the magnitude of potential Fed expectation repricing remains considerably larger compared to the ECB’s.