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.
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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.
A significant disconnect is emerging between Fed policy and inflation data. The Federal Reserve is signaling a dovish shift, prioritizing labor market risks and viewing inflation as transitory, even as forecasts show both headline and core inflation accelerating into the fourth quarter.
A strategy for US investors to counter domestic market risk involves buying European bonds and not hedging the currency. This combines a modest ~3% bond yield with an expected ~7% appreciation of the euro against the dollar, driven by diverging central bank policies.
In 2026, major central banks will diverge significantly. The U.S. Fed and ECB are expected to cut rates in response to slowing growth and disinflation. In stark contrast, the Bank of Japan is poised to hike rates as it finally achieves reflation, making it the sole hawkish outlier among developed market central banks.
Contrary to conventional wisdom, a rate cut is not automatically negative for a currency. In economies like Sweden or the Eurozone, a cut can be perceived as growth-positive, thereby supporting the currency. This contrasts with situations like New Zealand, where cuts are a response to poor data and are thus currency-negative, highlighting the importance of economic context.
The initiation of the Fed's cutting cycle is the critical trigger for a weaker dollar against EM currencies, outweighing any mixed forward-looking commentary. This is because the cycle's start begins to erode the US carry advantage, a key structural factor supporting EM FX performance.
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 Federal Reserve's dovish stance, combined with a resilient global growth outlook, creates a favorable environment for "pro-cyclical" currencies like the Australian Dollar and Norwegian Krone. This "middle of the dollar smile" scenario suggests betting on currencies sensitive to global economic momentum, not just betting against the dollar.
Current rate cuts, intended as risk management, are not a one-way street. By stimulating the economy, they raise the probability that the Fed will need to reverse course and hike rates later to manage potential outperformance, creating a "two-sided" risk distribution for investors.