What happens to the euro when the ECB cuts first

Futures on the euro short-term rate (€STR) show near-certainty of a 25-basis-point cut at the European Central Bank's 6 June meeting, and currency desks are positioning for the two central banks to diverge. The ECB wants to revive a sluggish eurozone economy. The Federal Reserve is still pinned down by stubborn US inflation.

A cut already in the price

The ECB has done little to discourage the pricing. Its policymakers have spent weeks preparing markets for a June move, and a deposit rate of 4 per cent, the highest in the euro's history, looks restrictive with inflation near target. The Fed, holding at 5.25-5.5 per cent, has watched three hot months of inflation at the start of the year push its first cut further out. The gap between the two policy rates, already wide, is set to widen further on Thursday.

Two years of catching up

The ECB came late to the tightening cycle and left it with rates at a record. It raised rates ten times between July 2022 and September 2023, taking the deposit rate from minus 0.5 per cent to 4 per cent, as eurozone inflation climbed above 10 per cent in the autumn of 2022 on the back of the energy shock that followed Russia's invasion of Ukraine. Headline inflation has since fallen to 2.6 per cent in May, close enough to the 2 per cent target for most of the Governing Council to judge that policy is tighter than it needs to be. The Fed began earlier and went further, and its fight with services inflation is proving the harder of the two.

The difference reflects the nature of each shock. Europe's inflation came mostly through imported energy and food, which reversed as gas prices fell back. America's owed more to strong domestic demand, a tight labour market and generous fiscal support, all of which fade more slowly. A central bank facing an imported shock can ease sooner once the shock passes, which is roughly the argument the ECB's doves have been making since the start of the year.

Rates push, growth pulls

A wider gap between policy rates should push the euro down against the dollar. But currencies follow growth as much as interest rates. If cheaper borrowing sparks an industrial recovery in Europe while sticky inflation slows the US economy, the euro could hold up better than the rate spread alone would suggest.

The euro has already had one lesson in how far a rate gap can push it. In 2022, with the Fed tightening aggressively and the ECB still holding rates below zero, the euro fell below parity with the dollar for the first time in two decades. Europe was then also suffering a collapse in its terms of trade as it paid far more for imported gas. Neither condition is as severe now, which is one reason currency strategists expect a gentler decline this time.

The rate channel works through carry. A fund that borrows in euros and holds dollar deposits or Treasury bills pockets the difference in yields, and each widening of the spread makes that trade more attractive, adding steady selling pressure on the euro. The growth channel works through equity and direct investment. Money flows towards the economy whose earnings are improving, and if European profits start to recover faster than American ones, those flows can outweigh the carry.

Growth is closer than it looks

The growth story is less one-sided than the talk of American exceptionalism suggests. The eurozone economy grew 0.3 per cent in the first quarter, an annualised pace of a little over 1 per cent, while revised American figures showed annualised growth of 1.3 per cent. European manufacturing surveys, though still pointing to contraction, have climbed to their best levels in more than a year, while the ISM survey of American factories, published on Monday, slipped further below the line between growth and contraction.

When growth beat rates

There is a clear precedent for the euro rising against the rate spread. In 2017 the Fed raised rates three times while the ECB kept its deposit rate below zero, yet the euro climbed from about $1.05 to about $1.20 over the year as the eurozone recovery surprised on the upside. The opposite case came in 2014 and 2015, when ECB easing coincided with a strong American economy and a Fed preparing to tighten, and the euro fell hard. Which pattern applies this year depends on which economy surprises.

The case for a quiet reaction

The strongest objection to the bearish trade is that the cut is already priced. Currencies move on surprises, and a quarter-point reduction that futures have treated as near-certain for weeks tells the market nothing new. The path after June matters more. ECB officials have been careful to avoid promising a series of cuts, and wage growth in the eurozone picked up in the first quarter, which gives the hawks on the council a reason to insist on a pause. If the Fed, for its part, begins to see the softer growth that some of its officials expect, the spread may narrow from the American side later in the year.

Winners, losers and risks

A modestly weaker euro helps European exporters and hurts American multinationals that translate euro earnings back into dollars. The risks to the euro are not only economic. Elections to the European Parliament run from 6 to 9 June, and a strong showing by nationalist parties could revive worries about budgets in France and Italy. Standard & Poor's cut France's credit rating on Friday, citing its deficits, so those worries are not hypothetical. Germany's industrial base, squeezed by high energy prices and weak Chinese demand, may also fail to deliver the factory rebound the optimists need.

The calendar is crowded. American payroll figures arrive on Friday, and the May consumer price index lands on the same day the Fed announces its decision next week. Just as important is what the ECB says about July: a clear signal of a pause would limit the euro's fall, while any hint of back-to-back cuts would extend it.

The ECB is cutting ahead of the Fed, and the euro will probably dip at first as rate spreads widen. How far it falls after that depends on European growth, and a pickup in factory output later in the year would limit the damage. The likelier near-term result is a modest, grinding decline over the summer rather than a slide towards parity, with exporters in Germany and Italy the main beneficiaries and dollar borrowers in Europe the ones paying for it.