USD: Fed independence under the microscope

The Federal Reserve is entering a sensitive phase for its credibility. Markets worry that politics, rather than data, could be seen to drive policy, especially with speculation that Kevin Hassett, a strong advocate of aggressive cuts, might replace Chair Powell in May 2026. This week’s meeting will be an important test: futures price almost a 90% chance of a cut, but a split vote would highlight internal disagreement on how to support a cooling labour market while inflation holds near 3%.

The macro backdrop complicates the case for easing. Growth is slowing, real consumer spending has eased to around 2.1% year on year, and fiscal risks are building as the deficit widens and Treasury supply is set to increase. Longer-dated yields could stay elevated even if the Fed cuts, keeping mortgage and auto borrowing costs high and limiting the effectiveness of policy. For the dollar, this combination of fiscal strain, questions over central bank independence and a steeper curve points to a softer tone, even if the Fed struggles to validate the roughly 90bp of easing priced by early 2026.

GBP: Tactical rebound within a fragile backdrop

Sterling has enjoyed another strong week against the dollar, rising close to 1% to fresh one-month highs and outperforming most peers apart from AUD and JPY. GBP/EUR has also advanced for three weeks, though it remains in a broader downtrend while capped below its 200-day moving average. Positioning has become less negative since the UK Budget reduced fiscal risk premium, but domestic fundamentals still look challenging.

With a BoE cut expected this month and further easing likely in 2026, front-end gilts have scope to rally, compressing the roughly 25bp gap between the two-year yield and Bank Rate that history suggests should be close to zero. Near term, Friday’s GDP release is the key risk event. The UK’s tendency to underperform into year end means softer data could pull terminal rate expectations lower and weigh on sterling over a longer horizon, even if the current year-end rebound in GBP/EUR still has room to extend while risk appetite holds up.

EUR: Supported by rate differentials

The euro side of the two-year USD/EUR swap spread has firmed, supported by higher headline inflation and upward revisions to euro area PMIs and Q3 GDP. This has reinforced the view that the ECB will be slower to cut than some peers. The US leg of the spread, by contrast, remains more flexible as investors reassess the Fed’s path.

With rate differentials now playing a larger role in EUR/USD than earlier in the year, US data and Fed communication will drive most of the action. The eurozone calendar is relatively quiet, leaving the Fed decision as the main catalyst. We expect EUR/USD to hold above key moving averages, with support around 1.1640 and room to probe the 1.17 area, helped by seasonal dollar weakness and the perception that the dollar remains expensive relative to adjusted rate spreads.

Looking ahead 

Into year end and early 2026, FX markets are likely to trade around three themes: central bank independence, the balance between monetary and fiscal policy, and evolving rate differentials. In the US, doubts over the Fed’s autonomy and leadership succession are becoming as important as the growth and inflation outlook for the dollar. In Europe and the UK, the timing and pace of the easing cycles, and whether they can proceed without undermining inflation-fighting credentials, will be key.

For now, the dollar’s bias is lower, sterling is enjoying a tactical rally within a still fragile fundamental story, and the euro is underpinned by relatively firmer rate expectations.