The Estet-Sofar basis is in a "tug of war." Diverging rate policies, where the market prices Fed cuts against a European Central Bank on hold, support a wider basis. However, the Fed's accommodating balance sheet policy (T-bill purchases) relative to the ECB's supports a narrower basis. This results in an expectation for the basis to remain in a tight range, albeit with a slight widening bias.
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Contrary to typical risk-off behavior, a financial shock originating in the US would likely be positive for the EUR/USD exchange rate. This is because it creates more room for the US Federal Reserve to reprice its policy downwards and can trigger repatriation flows out of US equities.
J.P. Morgan maintains a constructive stance on the Eurodollar due to its asymmetric response to Fed pricing. The currency strengthens more when the Fed's terminal rate is priced lower but shows stickiness when it's priced higher, creating a favorable risk-reward profile for bullish positions despite lowered upside targets.
Cross-currency basis is significantly influenced by predictable seasonal trends in bond issuance. "Yankee" issuance (foreign entities issuing in USD) is historically strong in January, creating narrowing pressure, but is expected to decline. Conversely, "Reverse Yankee" issuance (US entities issuing abroad) starts slowly and picks up in February, supporting a widening of the basis.
A significant policy divergence is expected in Europe. The ECB is forecast to hold rates steady, balancing cyclical growth against structural weaknesses. In contrast, the Bank of England is projected to deliver three cuts, driven by the UK's unique combination of rising unemployment and a rapidly improving inflation outlook.
Morgan Stanley holds a contrarian view that the European Central Bank will cut rates in June and September. This is based on the expectation that an upcoming inflation print will fall below the ECB's target, fundamentally shifting the policy debate. A below-target reading would reverse the burden of proof, forcing policymakers to justify not easing policy further.
The U.S. dollar's decline is forecast to persist into H1 2026, driven by more than just policy shifts. As U.S. interest rate advantages narrow relative to the rest of the world, hedging costs for foreign investors decrease. This provides a greater incentive for investors to hedge their currency exposure, leading to increased dollar selling.
Even if US inflation remains stubbornly high, the US dollar's potential to appreciate is capped by the Federal Reserve's asymmetric reaction function. The Fed is operating under a risk management framework where it is more inclined to ease on economic weakness than to react hawkishly to firm inflation, limiting terminal rate repricing.
The European Central Bank's stable, "on hold" position has created a low-volatility environment for European rates. This policy predictability supports specific trading strategies, such as tactical range trading, using call spreads instead of outright long duration, and shorting gamma to capitalize on the expectation of continued low delivered volatility.
A significant split in monetary policy is expected in 2026. The US Federal Reserve and European Central Bank are predicted to cut rates in response to slowing growth and easing inflation. In stark contrast, the Bank of Japan is on a hiking cycle, aiming to reflate its economy.
Despite facing similar pressures like high inflation and slowing labor markets, the US Federal Reserve is cutting rates while European central banks remain on hold. This significant policy divergence is expected to weaken the U.S. dollar and create cross-Atlantic investment opportunities.