The Euro's Weakening Against the US Dollar: A Trend Set to Continue?
The euro has been on a downward trajectory against the US dollar since the start of 2024, with its value declining by approximately 2.2%. Despite occasional minor recoveries, the EUR/USD exchange rate remains historically low, hovering just below 1.08 as of May 14. Several factors contribute to this trend, primarily rooted in the divergence of monetary policies and economic trajectories between the euro area and the United States.
Diverging Inflation Trajectories
Inflation dynamics in the eurozone and the U.S. are markedly different. In the euro area, inflation has steadily declined in 2024, with the headline Consumer Price Index (CPI) dropping to 2.4% year-on-year in April, down from 2.9% in January. This marks the lowest level since October 2023, reflecting the region’s success in reducing inflation from its October 2022 peak of 10.6%, driven largely by the energy price surge following the Ukraine conflict.
In contrast, U.S. inflation has remained elevated, with the CPI rising to 3.5% in March from 3.1% in January. This divergence in inflationary pressures has prompted the European Central Bank (ECB) and the U.S. Federal Reserve (Fed) to adopt starkly different monetary stances.
Monetary Policy Disparities
The ECB has aggressively raised policy rates since 2022 to curb inflation. However, with inflation nearing its target level of 2%, the central bank has shifted to a dovish stance, signaling potential rate cuts as early as June. Meanwhile, the eurozone economy shows signs of stagnation, with GDP growing by just 0.1% in the fourth quarter of 2023. Major economies, including Germany, France, and Italy, have struggled with prolonged contractions in manufacturing activity, amplifying calls for accommodative monetary policies to stimulate growth.
Conversely, the Fed has maintained a hawkish stance. U.S. economic resilience, highlighted by a 3.4% GDP growth rate in the final quarter of 2023, supports its "higher-for-longer" interest rate policy. While the U.S. economy showed slight softening in early 2024, its growth trajectory outpaces that of the eurozone, providing room for the Fed to sustain elevated rates.
Widening Bond Yield Spreads
The policy divergence has also widened the spread between U.S. and eurozone government bond yields. Anticipation of ECB rate cuts has attracted investors to European bonds, driving up their prices and inversely reducing yields. In contrast, U.S. bond yields remain higher due to the Fed’s policies, reinforcing the dollar’s attractiveness.
The positive correlation between a currency and its bond yields underscores this dynamic. Higher yields often signal stronger economic momentum, which boosts demand for the currency. This trend has consistently supported the U.S. dollar during the Fed’s rate hike cycles.
The Carry Trade Effect
Interest rate differentials further encourage carry trade strategies, where investors borrow in lower-yield currencies to invest in higher-yield ones. With the ECB’s overnight deposit rate at 4% compared to the Fed’s 5.25-5.5%, the dollar remains an attractive option for such trades. This dynamic exerts additional downward pressure on the euro while bolstering the dollar’s value.
Outlook: Euro Weakness Likely to Persist
Given the current economic and monetary landscapes, the euro is likely to remain under pressure relative to the dollar. The eurozone’s need for accommodative policies to support growth, coupled with the Fed’s hawkish stance, will likely sustain the divergence in interest rates and bond yields. This environment favors continued strength for the U.S. dollar, while the euro’s weakness may persist in the foreseeable future.
