Unicredit Tower A, Milan © Sergio Fabio Brivio, Flickr, licensing: CC 2.0.

Foreign exchange markets are underestimating the European Central Bank's resolve to maintain interest rates at current levels through the first part of 2024, according to a new analysis.

UniCredit Bank says the Euro can benefit and advance against the Dollar as market participants come to terms with the ECB's official communication that there is no imminent need to cut interest rates.

"At the start of 2024 central banks are likely to disappoint market expectations. Investors still appear to be pricing in too aggressive easing cycles by the Fed and the ECB this year," says Roberto Mialich, FX Strategist at UniCredit in Milan.

"We think, however, that the adjustment will probably be more intense along the eurozone than the US forward curve, allowing an EUR-USD recovery," he adds.

The new year has started with Dollar strength that takes the Euro to Dollar exchange rate back below 1.10, leading some analysts to warn that it will struggle to maintain levels above this key benchmark.

Central to this USD outperformance is the 'pricing out' of Federal Reserve rate cuts, with investors coming to terms with a robust economy that is not yet in need of Fed support via lower interest rates.

Market-implied pricing shows the chances of a Fed cut by March are now down to 63%, their lowest since the ~75% odds priced at the time of the December Fed meeting.

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The market is meanwhile confident the ECB will cut interest rates to around 2.5% by the end of the year, with the first move probably being delivered in March/April.

But Eurozone labour market data suggests this could be too soon; it was reported on January 09 that Eurozone unemployment had fallen to an all-time low, justifying the ECB's message that there is no need to rush into interest rate cuts.

Eurostat said the Eurozone's unemployment rate fell to 6.4% in November from 6.5% in October, helped by a fall in the number of unemployed of 99K, bettering the market's consensus expectation for an unchanged 6.5%.

The ECB says it will assess the wage settlements due in the first half of 2024 before deciding on whether to cut interest rates, and the record-low in unemployment could justify this call if it maintains above-trend wage agreements.

UniCredit expects the Fed and the ECB to start easing in June, with policy rates falling to 4.25% and 3.25% by 4Q24.

"A potential repricing of the Fed’s easing expectations, and the timing of the first rate cut in particular, might still allow the USD to hold its recent gains in the near term. However, this does not seem enough to challenge our call for a moderately weaker USD this year," says Mialich.

"In our view, the re-pricing in the ECB easing expectations will likely be even stronger, offering the pair some upside potential ahead, although probably still within the 1.10-1.13 band," he adds.