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With the European Central Bank (ECB) lowering its key rate during its June meeting and U.S. Federal Reserve policymakers poised to keep borrowing costs elevated through year-end, the interest-rate differential between the regions could have significant ramifications for currency exchange rates and accelerate the growth in European holdings of U.S Treasuries.

What We're Watching

Marking the bank's first interest rate cut in nearly five years, the ECB lowered the benchmark rate in the 20 countries that use the euro to 3.75% in its June 6 meeting, from a historic high of 4% where it had been since September. And the ECB isn't alone: central banks in Switzerland, Sweden, and Denmark have also lowered their policy rates this year, and the Bank of England looks poised to follow.

The move was unusual and all but unprecedented, given that only two other times in its history (and under extreme circumstances) has the ECB started a cycle of monetary policy easing before the U.S. central bank. During the euro crisis in 1999 and the eurozone debt crisis in 2012, the ECB cut rates without the Fed following suit. (The Fed in 2012 was at effective lower bound and was loosening conditions through quantitative easing.)

This month's rate cuts are notable in that the ECB has preceded the Fed on the grounds of a cyclical slowdown in inflation. Making the move doubly striking is the continent's current geopolitical upheaval and the risk of heightened political uncertainties at the heart of the euro area, alongside some market participants' concerns that the ongoing shrinking of Europe's share of the global economy is stoking fears that the monetary union can't keep up with the growth of the U.S. and China.

ECB Chief Economist Philip Lane has suggested that the key rate will stay at its current level over the coming months as policymakers wait to see sustained disinflation in the services sector and a clear downward path in wage growth before easing policy any further.

However, the ECB has clearly become comparatively comfortable with the path of inflation--especially in contrast with Fed officials, who this month maintained the federal funds rate at 5.25-5.5%. The June 11 Federal Open Market Committee meeting was the U.S. central bank's seventh consecutive consortium without a change, keeping the key rate at its highest since the 5.5% it reached just before the global financial crisis. Fed policymakers also signaled fewer near-term rate cuts than previously estimated, penciling in just one move this year--rather than the three they previously forecasted in March. The central bank also now expects inflation to be stickier than expected through year-end.

Outcomes of this decoupling of the eurozone and U.S.'s initial interest rate cuts will likely manifest in diverging foreign exchange rates and capital flows as investors seek higher-yielding assets. This may manifest in more European investors turning toward U.S. markets. In some ways, these effects have already started to take shape, considering how the euro is weakening against the dollar and Europe has become the largest foreign holder of U.S. Treasury debt.

What We Think And Why

The widening interest rate differential between the two economic powerhouses is likely to continue to weigh on the euro's valuation vis-à-vis the dollar. This, plus increased political uncertainties in Europe, have led us to postpone our expected reappreciation of the euro against the dollar. We no longer expect the euro to regain its fair value against the dollar (which is around 1.14, compared with 1.07 today) before 2026, a year later than previously expected.

At the same time, we expect an acceleration in the flow of funds from Europe to the U.S.--continuing a trend that began before the pandemic.

Europe generates abundant savings, which would normally be beneficial to the financing of its borrowing needs. But a report in April (commissioned by the French Finance Minister Bruno Le Maire and overseen by Christian Noyer, the French economist who served as Governor of the Bank of France) suggested these savings are "poorly allocated" and that the continent exports its savings by buying foreign debt securities. Additionally, the report argued that lack of depth in European capital markets is becoming "increasingly untenable" and warned that the monetary union can "no longer defer [this] deepening … if it wants to close the widening economic gap" with the U.S.

The Noyer report estimates that 20% of European savings are invested in non-European debt--representing the doubling of such holdings since 2012. In fact, Europe has become the biggest foreign holder of U.S. Treasuries securities--having surpassed China and collectively holding roughly 19% of outstanding U.S. government debt securities. Admittedly, China using custodian services located in the euro area to recycle parts of its foreign-exchange reserves in U.S. assets somewhat blurs the line of real treasury holdings. As the ECB flagged that it would soon lower its key rate, eurozone investors increased holdings of Treasuries in first three months of this year by $50 billion, to total $1.6 trillion.

S&P Global Ratings Economics believes that the longer the disparity in capital markets remains, and the longer the interest rate differential lasts, the more we will see capital flows from Europe to the U.S.

That said, as the Fed begins to play monetary policy catch-up, the rate differential is likely to shrink over the next two years.

We expect the ECB will cut rates once at the end of each quarter until the third quarter of 2025 and finish with an "exit rate" of around 2.5%. We now forecast the Fed will hold off lowering rates until December before picking up the pace of easing in 2025 as economic growth slows below potential. We project that it will cut rates 100 basis points over the course of next year, to 4%-4.25% at year-end.

What Could Change

While the ECB has begun its easing cycle, there's no guarantee of a periodic, predictable lowering of rates. Economic growth could surprise on the upside; inflationary pressures could reignite.

Meanwhile, as the Fed waits for more evidence that inflation is approaching its 2% target, recent economic resilience could prove fragile. If the world's biggest economy suffers a sudden or sharper-than-expected slowdown, the central bank could bring its first rate cut forward--especially if unemployment surges and wages suffer, which would force the Fed to focus on its role in stabilizing the labor market. Alternatively, U.S. economic outperformance could continue, further pressuring prices and underpinning the labor market. In our view, the Fed is unlikely to begin hiking rates again. At the same time, it is also unlikely to lower the key rate until policymakers see several consecutive monthly readings of slowing 2% annualized month-over-month core inflation.

Writer: Joe Maguire and Molly Mintz