EUR/USD adjusts for Interest Rate Differential Amid Anticipated ECB Rate Cut
The Euribor rates term structure currently discounts 65 basis points from the European Central Bank’s interest rate, which stands at 4.25%. At the same time, the 12-month Euribor, currently at 3.072%, forecasts a significant 120 basis point reduction in the Euro Area’s interest rate. Considering the Euro Area’s inflation expectations, which are pegged at 2.8%, these interest rates suggest an outlook characterized by low inflation and moderate to low economic growth over the forthcoming 12-month period.
These graphs visually compare the main ECB interest rate at 4.25% with the 3-Month Euribor rate of 3.49%. Additionally, they depict the forward discounting of the Euro Area interest rate term structure, reflecting the economic growth prospects. The Euro Area experienced a year-on-year growth of 0.9% in Q2 and a quarter-on-quarter growth of 0.3%, indicating moderate to low output growth.
The intraday EUR/USD forward curve has seen a slight decline of -0.3%, aligning with the spot EUR/USD at 1.1036. We can observe the forward rates, with the 1-Month Forward EUR/USD at 1.1056, the 3-Month Forward Rate EUR/USD at 1.1084, and the 1-Year Forward Rate EUR/USD at 1.1194. These levels suggest an average 10-cent Euro premium on the Dollar. However, the interest rate differential between the Euro and the USD should theoretically favor the USD, while other factors such as economic growth differential, balance of trade, deficits, and financial flows must be considered, potentially creating arbitrage opportunities in the marketplace.
When we evaluate the EUR/USD exchange rate based on Interest Rate Parity, the 1-Month and 3-Month EUR/USD spot rates differ significantly from the current forward rates. Applying the Interest Rate Parity to the 1-Month Forward (1.1056/(1+0.05246)/(1+0.03595)), the EUR/USD equals 1.088. Therefore, the 1-Month forward exchange rate based on Interest Rate Parity equates to 1.088 compared to the 1.1056 of the 1-Month Forward, indicating a mispricing in FX markets. Similarly, using the same pricing method, the 3-Month EUR/USD spot equals 1.0919 compared to the 1.1084 of the 3-Month Forward rate.
Where will EUR/USD go?
With the EUR/USD 1.1037 spot chart on a daily timeframe, varying by the minute, it’s possible to see that the FX market has built points of control volume areas at EUR/USD 1.0944 and EUR/USD 1.085. With the drifting EUR/USD exchange rate price line and the Interest Rate Parity framework considering a 25 basis points decrease in the Federal Funds Rate and another 25 basis points decrease in the ECB interest rate, in the near term, the EUR/USD exchange rate will converge to EUR/USD 1.095, although higher volatility has to be considered.