European currencies have been rebounding strongly versus the U.S. dollar since hitting bottom in late September 2022 during the Gilt crisis when yields on U.K. government bonds surged.  The rally in European currencies accelerated in July 2023 following the release of the U.S. inflation statistics (Figure 1). 

Figure 1: EUR and GBP have rebounded strongly in recent weeks and months

Recent U.S. and European inflation data are highly divergent.  U.K. core inflation has climbed to above 7%.  Eurozone core inflation has risen towards 5.4% while the U.S. core consumer price index (CPI) has been falling towards 4.8%, down from a peak of 6.6% last year. 

What’s even more remarkable is that the divergence between U.S. and European inflation rates is much stronger when one measures it in a consistent fashion.  The U.K. and European Union (EU) use a “harmonized” measure that is consistent across Europe.  The harmonized measure includes rents of actual rental properties but, unlike the standard U.S. numbers, does not assume that homeowners rent properties from themselves.  Excluding the so-called owners’ equivalent rent (OER) from the U.S. numbers makes a huge difference. At the moment, the assumption that homeowners rent properties from themselves has exaggerated U.S. core inflation to the tune of 2.5%. 

The U.S. Bureau of Labor Statistics produces what they term an “experimental” harmonized measure of core-CPI that gauges inflation the same way as in Europe and therefore excludes the OER component.  This shows core inflation in the U.S. to be 2.3%, far below European levels and trending lower rather than higher (Figure 2). 

Figure 2: Measured consistently, U.S. core inflation is half to one-third European levels

This suggests that the U.S. Federal Reserve (Fed), which appears to be preparing a 25-basis-point (bps) rate hike on July 26, could soon have its policy rate at more than 3% above the level of harmonized core inflation (Figure 3).  Meanwhile, the Bank of England (BoE), which just raised rates to 5%, still has rates more than 2% below its rate of harmonized core inflation (Figure 4).  The European Central Bank (ECB) has its main refinancing rate at 4%,  1.4% below the level of the eurozone’s harmonized core inflation (Figure 5). 

Figure 3: Fed Funds now exceed harmonized U.S. Core CPI by 3%, the most since 2007

Figure 4: The BoE’s policy rate is still 2% below inflation

Figure 5: The ECB has its policy rate 1.4% below Eurozone core inflation

The differences in the level of real rates (policy rates minus harmonized core inflation) suggests that the Fed may have overtightened policy and may need to reduce rates sooner than expected by market participants.  By contrast, those same measures suggest that the European central banks may still be behind their inflation curve and may need to tighten policy even more substantially.  Indeed, forward curves have moved significantly in the direction of this thinking in recent weeks and now price just 25 bps more in rate hikes for the Fed compared to 75 bps for the eurozone and 125-150 bps in the U.K.

Elsewhere, the U.S. yield curve is much more sharply inverted than yield curves in the eurozone or the U.K.  This may also lead currency traders to look past the Fed’s last expected rate hike and towards possible rate cuts if monetary overtightening produces a downturn in the U.S. sooner than it does in Europe. 

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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