Speculations are rife whether the Fed will cut interest rates by 25 or even 50 bps in September, while the ECB is also estimated to reduce its rates too. The ECB Governing Council member François Villeroy de Galhau called for extra easing after the rate of inflation in the euro area declined sharply to 2.2% in August. Since the Fed and the ECB are expected to reduce their rates further, the EUR/USD is likely to remain range-bound.
How can rate cuts affect the EUR/USD?
The EUR/USD tends to mirror the yield difference between the German 10-year Bund and the US 10-year Treasury bond. At the moment, the market is anticipating a bigger rate cut from the Fed than the ECB which has managed to slightly push up the EUR/USD.
Fed rate cuts
JPMorgan has projected that the interest rate is forecasted to be reduced by 100 basis point by year-end by the Fed. Analysts expect that in the next three meetings the Fed is likely to deliver a one 50-basis-point cut and two 25-basis-point rate cuts. However, if inflation increases or unemployment proves sticky, market sentiment concerning the Fed’s rate cut path may shift.
Factors that may impact the value of the EUR/USD
- Rate differential
The key question is which one of the two, the Fed or the ECB, will cut rates more aggressively. At the present time, in the US, the interest rate minus inflation is 2.43%, while in the Eurozone, it is 2.05%. This will enable the Fed to have more scope to cut rates to spur the economy, something that has lifted the EUR/USD. Furthermore, low interest rates in the US may discourage foreign direct investment and therefore lead to a depreciation of the dollar.
- Foreign Direct Investment (FDI)
Apart from the rate differential, we need to take into account the foreign direct investment (FDI) which rises when the Fed raises rates and drops when the Fed cuts rates. When the Fed begins to reduce rates, global FDI tends to come down resulting in a weaker dollar. But once the initial FDI reduction has happened, the FDI again starts coming in and this reinforces the value of the dollar.
- Eurozone economy vs. US economy
The economy of the Eurozone is expected to decelerate more than the US economy in Q1 2025, with Germany’s economy entering into negative territory and slowing down by 0.1% in Q2 2024, which may increase fears of a recession.
With consumer confidence weakening, lower investments and an economy that has underperformed, the economic outlook of the Eurozone appears gloomy. So, if the ECB decides to reduce rates at a steeper rate than the Fed, then there is a likelihood that the EUR/USD pair will depreciate.
Greenback’s safe-haven status and its influence on FX
Safe-haven currencies are an important asset for global investors, particularly during periods of significant market volatility or geopolitical uncertainty. During periods of risk-off, investors turn to safer assets and away from riskier ones to mitigate risk and protect their capital. The USD is one of the key safe-haven currencies for several reasons. It is the world’s reserve currency held by major central banks and financial institutions. The US’s dominant economic position and the widespread use of its currency in global trade make the greenback the preferred safe haven. The USD accounts for 60% of the global foreign reserves whereas the euro holds only 20%. As we know, in critical situations, such as during geopolitical tensions, pandemics or wars, investors turn to the USD which results in boosting the value of the dollar index and devaluating other currencies. However, after the initial rise, and as demand drops with currency swaps, the dollar weakens and therefore the EUR/USD increases.
It is not certain how the EUR/USD will react in the next few months as this will mainly depend on the ECB and Fed’s interest rate decisions. Investors should remain cautious as the elevated geopolitical risks and the political gridlock of the Eurozone could weigh on the euro. At the same time, it is also not clear to what extent the dollar will weaken moving forward.