They say that those who are drowning must save themselves. When then-ECB President Mario Draghi uttered his famous phrase in 2012 about being ready to do “whatever it takes” to save the single currency, few believed this scenario would repeat itself 14 years later. Yet today, the yield spread between French and German government bonds has pierced the historical highs of those very years. This is a stark indicator of off-the-charts political risks in the Eurozone, relentlessly dragging EURUSD quotes to the bottom.
The macroeconomic situation in France looks extremely alarming. Public debt already stands at 118% of GDP and could breach the 120% mark by 2027. As bond yields rise, debt servicing costs will skyrocket from the current €66 billion to €124 billion by the end of the decade, while the budget deficit will exceed a critical 5.7% of GDP. Such figures blatantly violate EU fiscal rules, forcing the government to implement unpopular austerity measures. However, the opposition, which controls parliament, is blocking these initiatives—a situation that has historically led to a string of prime ministerial resignations. Another political crisis is inevitable, and it is already triggering capital flight and a new surge in borrowing costs.
Under these conditions, the ECB may be forced to put Draghi’s very rhetoric into practice. We cannot rule out a scenario where the regulator is compelled to start directly purchasing French bonds to cap their yields. In effect, this means a return to quantitative easing (QE)—a tool of monetary expansion that, unlike rate hikes, exerts powerful downward pressure on the euro’s exchange rate.
Against this backdrop, the Federal Reserve’s dilemmas look entirely different. Richmond Fed President Thomas Barkin figuratively compared the central bank’s dual mandate to raising two children: while the labor market is bringing home “excellent grades,” inflation requires “serious disciplinary talks.” And, it seems, one heart-to-heart talk will not be enough. The futures market is already pricing in a 54% probability of another federal funds rate hike as early as October.
FOMC members are increasingly expressing concern over second-order effects, where energy price spikes begin to seep into core inflation. The protracted conflict in the Middle East creates the risk of even more aggressive monetary tightening than we witnessed in 2022. For comparison: 200 days after the onset of the Russia-Ukraine conflict, oil was trading $7 lower than its starting levels. Today, however, amid the escalation and US and Israeli strikes on Iranian territory in late February, a barrel of oil is $25 more expensive than before these events.
As the saying goes, nothing is more permanent than the temporary. Morgan Stanley analysts forecast that by the end of 2027, US inflation will settle at 2.7%, which is above the Fed’s 2.5% target. This implies that the rate hike cycle will be longer and deeper than previously anticipated. And this circumstance plays entirely into the hands of the US dollar, which now doesn’t even need to exert special effort to strengthen—it simply needs to watch the mounting problems of its main competitors.
