The appreciation of the euro against the dollar will lead the European Central Bank (ECB) to lower interest rates further in 2025, even though by itself this is unlikely to weaken the euro, which will make it less likely that the U.S. administration will pursue destabilizing financial policies aimed at weakening the dollar further. Despite expectations that protectionist U.S. trade policies would lead to an appreciation of the dollar, the U.S. currency has depreciated since President took office in January. Meanwhile, U.S. equity markets have reached or remain close to all-time highs, despite the risk of trade-related economic disruption. Thus far, dollar depreciation has been orderly, suggesting it is driven by a gradual shift of private investors into non-dollar-denominated, including euro-denominated assets.
> Since President Trump took office in January, the dollar has depreciated 11% against the euro. The dollar has also depreciated in trade-weighted terms, meaning against a broader basket of currencies.
> The dollar-euro interest rate differential has widened year-to-date. The Fed has left its policy rate unchanged at 4.25-4.5%, while the ECB has lowered its policy rate by a cumulative 100 basis points. A widening rate differential in favor of the dollar should have, all other being equal, led to dollar appreciation.
Higher U.S. tariffs combined with a stronger euro will weigh on euro area inflation and economic growth and will lead the ECB to lower interest rates by another 25-50 basis points this year. The dollar-euro interest rates differential will not change significantly with the ECB lowering rates by 25-50 basis points this year, and the Federal Reserve (Fed) by 0-0.75 basis points. A high level of uncertainty will continue to attach to U.S. economic policies and the U.S. inflation outlook. While increased government spending in Europe, particularly by Germany following the reform of the debt break, will help support domestic demand, a stronger euro and higher U.S. tariffs will weigh on exports. Nonetheless, the outlook for increased investment and defense spending will help attract investment into the euro area, further helped by erratic, dollar-negative U.S. economic. Increased investment and more predictable euro area policies will also support the greater diversification into euro-denominated assets.
> Euro area inflation has declined to the ECB’s two-percent target in June. Markets and analysts expect the ECB to lower interest rates by 25 basis point one more time, bringing the policy rate to 1.75%. The ECB has lowered its policy rate from 3% at the beginning of the year to 2%.
> In its April World Economic Outlook, the IMF forecasts U.S. real GDP growth of 1.8% and 1.7% in 2025 and 2026, respectively. Meanwhile, the respective forecasts for the euro area are 0.8% and 1.2%.
> While the euro area’s second and third largest economies, France and Italy, have limited room to increase fiscal spending, Germany has committed to spending an additional $ 1 trillion on infrastructure and defense over the next few years, which is a sizeable amount given euro area GDP of EUR 15 billion. This has helped make previously undervalued European equities more attractive to investors.
A weaker dollar and highish U.S. interest rates are suggestive of concerns about erratic U.S. economic policies, including attacks on the Federal Reserve as well as large fiscal deficits and increasing government. Strong U.S. equity markets suggest investor optimism in the context of the ongoing AI boom, the Trump administration’s deregulation agenda and the relative growth outperformance of the U.S. economy vis-à-vis Europe. A combination of high U.S. interest rates and sizeable fiscal deficits has historically led to a strong dollar. The significant uncertainty attaching to U.S. trade and foreign economic policies helps explain why investors are eager to increase their holdings of non-dollar assets. A weaker dollar, the risk of lower interest rate due to government pressure on the Fed, and deregulation also benefit U.S. equity valuations, while weakening demand for dollar-denominated fixed income assets. Increased concern about Fed independence and more broadly erratic U.S. economic policies may also explain the unusual behavior of the dollar and treasuries following the announcement of reciprocal tariffs when both the dollar and U.S. treasuries sold off.
> U.S. headline and core personal consumption expenditure inflation, the Fed’s preferred inflation gauge, reached 2.3% and 2.7% year-on-year, and thus remained above the Fed’s two-percent inflation target. In its Summary of Economic Forecasts, the Fed forecasts 50 basis point worth of interest rate cuts this year. U.S. unemployment was 4.1% in June, suggesting a tightish job market, not conducive to rapid disinflation.
> The Congressional Budget Office estimates that the budget reconciliation bill will add $3-4 trillion worth of debt until 2035, or roughly 10% of 2035 GDP), compared to a scenario where the cuts would have expired. Continued large fiscal deficit will lead to an increase of the debt-to-GDP ratio, which currently stands at 100% of GDP/
A weaker dollar will help limit the incentives for the Trump administration to pursue unorthodox, risky and potentially destabilizing financial policies aimed at further weakening the dollar in the context of continued large U.S. trade deficits. Uncertainty about U.S. economic policy, including trade policy, will continue to weigh on the dollar. The interest rate differential is not change much, if at all in the dollar’s favor this year. Whether recent dollar weakness will lead to a tangible narrowing of the U.S. trade deficit remains to be seen. Even if it did, it would not lead the U.S. administration to pursue less protectionist policies than it would otherwise have done. However, given the risk attached to other “unorthodox” financial policies aimed at weakening the dollar that various members of the Trump administration have floated, including a tax on capital inflows or foreign holdings of U.S. assets, or a restructuring and maturity extension of U.S. debt held by foreigners (Mar-a-lago accord), a weaker dollar will make such policies less likely to pursued. Anecdotal evidence suggests that it was the unusual instability and volatility of the U.S. treasury that led the Trump administration to suspend tariffs in April. The Treasury will be opposed to any market-destabilizing financial policies aimed at further weakening the dollar, and even the president is likely to balk given the April events.
> During the electoral campaign, Donald Trump floated a tax foreign capital inflows. Members of the Trump administration have floated the idea of asking allies to restructure their holdings of U.S. government debt to reduce U.S. interest payments and possibly weaken the dollar. Congress almost approved a so-called “revenge tax” in the context of the recent budget reconciliation bill that would have allowed the U.S. authorities to impose additional, targeted taxes on foreign holdings of U.S. assets. Any of these measures has the potential to seriously undermine foreign investor confidence, raising the risk of significant dollar and U.S. treasury market volatility.