EUR/USD: Euro at Risk of Major Breakdown as the ECB Prepares to Cut Rates

The ECB is setting the stage for interest rate cuts just as Fed stimulus bets unravel after hot inflation data

• The euro marked its worst day in 11 months as the dollar soars on hot CPI data.
• An ECB policy meeting is now in focus, with a rate cut signal expected.
• A widening yield disadvantage may push the euro below mission-critical support.

The euro plunged against the U.S. dollar as hotter-than-expected inflation data pushed down Federal Reserve interest rate cut expectations (as expected), sending greenback sharply higher against its major counterparts. The single currency shed over 1%, marking the worst one-day performance since May 15, 2023.

The March edition of U.S. consumer price index (CPI) data showed inflation accelerated to 3.5% year-on-year last month, topping forecasts of 3.4%. The core measure excluding volatile food and energy prices—a focal point for the Fed—held steady at 3.8%. It was expected to tick down to 3.7%.

From here, the spotlight turns to a monetary policy announcement from the European Central Bank (ECB). President Christine Lagarde and the Governing Council are expected to keep the target deposit rate unchanged at 4% while preparing to begin cutting borrowing costs in the second half of the year.

Is the ECB finally ready to cut interest rates?

As it stands, benchmark ESTR interest rate futures price in 74 basis points (bps) in ECB rate cuts this year. The probability of a standard-sized 25bps reduction at the central bank’s June meeting is now trading at 84%. Another is on the menu for September and a third by December. The likelihood of a fourth cut is now 32%.

The central bank seems to have the necessary ingredients in place to begin loosening its policy stance. Inflation surprised on the downside in March (as suspected), with headline CPI falling to 2.4% year-on-year. Economists penciled in 2.6% ahead of the release.

Continued progress looks likely. The impact of food prices—the largest upside contributor to overall inflation in 2023—has narrowed to the smallest since November 2021. More of the same looks likely as global food costs continue to decline, showing up in CPI with a lag of about seven months.

The top problem area is now the hospitality sector. This seems likely to unravel as economic weakness takes its toll. The latest purchasing managers index (PMI) data showed Eurozone economic activity contracted for a ninth consecutive month in March as deterioration in the manufacturing sector offset a slight pickup on the services side.

The euro may drop as yield spreads move against it

Financial markets appear to agree. Germany’s two-year breakeven rate—a measure of near-term inflation expectations priced into the bond markets—is hovering just below the ECB target of 2%. This suggests traders find credible the central bank’s ability to deliver on its mandate within its desired timeframe.

If the central bank delivers as expected, the euro willfaced a daunting interest rate disadvantage against the dollar. After the U.S. CPI surprise, Fed is priced in to cut rates by just 35bps. If that pushes prices through support above the 1.07 figure, a slide to test below the 1.05 mark may follow. Range resistance is clustered just below 1.10.

Ilya Spivak, tastylive head of global macro, has 15 years of experience in trading strategy, and he specializes in identifying thematic moves in currencies, commodities, interest rates and equities. He hosts Macro Money and co-hosts Overtime, Monday-Thursday. @Ilyaspivak 

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