Three straight months of hotter-than-expected inflation in the US have thrown a wrench into the Federal Reserve’s plans. Investors who were betting on rate cuts this year are now scrambling, with many fearing no cuts at all.
This has been a boon for the US dollar. With the Fed on hold, the dollar is strengthening against other currencies, especially the Euro. This “policy divergence trade” is fueled by the contrasting situations at the world’s two major central banks.
The Fed is now seen as more cautious, with some brokerages predicting just one or two cuts, pushed back to later in the year. Meanwhile, the European Central Bank (ECB) is signaling rate cuts of their own, potentially starting as early as June.
This divergence is widening the gap between the two central banks. Markets are betting on less than two cuts from the Fed, while expecting at least three from the ECB in 2024.
The widening gap between US and European interest rates is reflected in the bond market. The spread between US and German bond yields has hit its highest level since 2019. This trend suggests further weakness for the Euro, with some expecting it to fall below 1.05 against the US dollar.
In short, the hot inflation data has put the brakes on Fed rate cuts, while the ECB is poised to move in the opposite direction. This policy divergence is boosting the US dollar at the expense of the Euro.