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The market remains too optimistic about the prospect of Federal Reserve rate cuts, and disappointment will lead to a notably weaker Euro over the first quarter of 2024.

This is according to a new assessment from Rabobank, that judges "investors are still too optimistically positioned for Fed rate cuts."

Rabobank FX Strategist Jane Foley says the market currently sees scope for a 64 bp reduction in the Fed funds target on a 6-month view.

These expectations follow a reduction in rate-cut bets through the opening stages of the year as investors confronted ongoing robust U.S. economic data that challenges any need for Fed support via lower interest rates.

The repricing in rate cut expectations helped the Dollar outperform in the opening week of the year, with more to come.

"We expect further correction in this outlook and consequently expect the USD to see some support on a 1-to-3-month view," says Foley.

On the Eurozone side, Rabobank expects the EUR to perform poorly in the months ahead, largely due to weakness in the German economy.

This week saw Germany print weak industrial production statistics for November, at -0.7% m/m.

Rabobank's economists expect a second quarterly contraction in GDP to be confirmed.

"This would indicate that Germany was in recession at the end of 2023," says Foley.

Economists expect Germany's soft economic outturn to be further burdened by fiscal consolidation after Germany’s Constitutional Court ruled against the government's intention to use covid-era funds for existing budgetary needs.

"Funding gaps will now be filled with cost savings which will drag down the growth outlook further and potentially slow structural reforms," explains Foley.

Taken together, Rabobank sees scope for the Euro to Dollar exchange rate to dip to 1.05 on a three-month view before the impact of Fed rate cuts boosts risk appetite and weakens the USD in the second half of the year.