The pace of disinflation in most advanced economies is following a similar path, albeit with differences in sticky components. Central bank policy rates are unlikely to diverge significantly (our baseline), but this does not rule out the ECB and the BoE cutting rates faster than the Fed, especially given their weaker growth outlook. The impact of this scenario would be steeper yield curves in the Eurozone and the UK, but not substantially weaker exchange rates, as some fear. A bigger risk to European exchange rates stems from (unanticipated) energy price shocks rather than lower relative interest rates. We explore why.
Key takeaways
- The divergence of Central Bank policy rates is unlikely to significantly impact exchange rates, as other core currencies are not weak relative to recent history and market expectations of terminal rates in Europe are similar to those in the US.
- Global financial conditions are strongly influenced by US longend yields, and there is a risk of the term premium rising if US deficit and debt projections deteriorate.
- Although not in our baseline scenario, an energy supply and price shock would weaken European exchange rates and rapidly transmit to domestic inflation.
The US dollar has been exceptionally strong, but other core currencies (except the Yen) have also been strong in trade-weighted terms.
The global macro backdrop – inflation scares, geopolitical tensions and recession worries – together with US economic resilience, have supported the dollar versus core currencies, but the latter are not weak relative to recent history. Moreover, the difference in market expectations of terminal rates in Europe are now substantially higher than before the pandemic, and not materially different from expected US terminal rates. This should limit any sustained weakness in European exchange rates.
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