Published on: 2026-01-27
At the outset of 2026, the US dollar maintains a yield advantage over the euro, although this differential is diminishing. Market participants are increasingly viewing the currency through a geopolitical lens rather than as a straightforward macroeconomic trade. By late January, EURUSD had stabilised near $1.17, indicating a softer dollar than the previous year's highs and a more resilient euro than anticipated following multiple European shocks.
The 2026 outlook appears straightforward: the Federal Reserve maintains a policy rate range of 3.50% to 3.75%, while the European Central Bank (ECB) deposit facility rate stands at 2.00%. However, the primary issue extends beyond the headline interest rate spread. The key question is whether geopolitical developments will sustain demand for dollar funding, or if narrowing rate differentials and reduced hedging costs will allow Europe’s external surplus and fiscal improvements to translate into lasting euro strength.
The base case for 2026 is modestly favorable to the euro, though not decisively bullish. The most likely scenario is a range-bound market in which the euro benefits from a narrowing interest rate gap, while the dollar continues to find support during risk events and periods of elevated global funding demand.
The divergence in interest rates is diminishing, which is more significant than the absolute level of rates. Federal Reserve officials project a median policy rate of approximately 3.4% by the end of 2026, suggesting additional easing from current levels. Should the ECB maintain a neutral stance with fewer rate cuts than anticipated, the interest rate differential that has supported the dollar may narrow further.
Geopolitical factors provide structural support for the dollar, but they also introduce a risk premium. As US policy increasingly relies on tariffs, sanctions, and extraterritorial measures, global investors often demand greater compensation for holding unhedged dollar risk, despite the continued need for dollars for settlement and collateral.
A key but underappreciated driver for 2026 is the mechanics of foreign exchange hedging. As US interest rates decline relative to euro rates, the cost of hedging dollar-denominated assets for euro-based investors decreases. This shift can influence portfolio allocation decisions and provide sustained support for EURUSD through rebalancing flows.
Macro fundamentals have become more balanced. US inflation remains above target, with the Consumer Price Index (CPI) rising 2.7% year-on-year in December, while euro area inflation is near target, with the Harmonised Index of Consumer Prices (HICP) at approximately 2.1% in late 2025. (bls.gov) This convergence reduces the rationale for a persistently wider US real yield advantage.
The Fed’s current policy range of 3.50% to 3.75% already embeds a meaningful pivot from the post-pandemic peak. In its latest projections, the median path implies a federal funds rate around 3.4% by end-2026, alongside 2.3% real GDP growth and 2.4% PCE inflation (2.5% core).
This matters for EURUSD because the dollar’s multi-year advantage has been driven less by spot yields and more by forward pricing: higher US short rates made it expensive to hedge dollars, thereby tilting global capital allocation.
The ECB deposit facility rate sits at 2.00%. The euro area macro profile also looks more stable than the market narrative often implies. Staff projections point to 1.2% euro area growth in 2026 and 1.9% HICP inflation, with domestic demand gradually improving.
If euro area inflation remains close to target and growth improves modestly, the ECB will have limited incentive to pursue aggressive rate cuts. This stability is a subtle but important factor supporting the euro in 2026: not a scenario of rapid European expansion, but one where sufficient stability allows the ECB to maintain a cautious stance as the Federal Reserve continues to ease policy.
Geopolitical stress has historically supported the dollar; however, conditions in 2026 may challenge the durability of this relationship.
The dollar benefits from three structural features in risk episodes: dollar invoicing in trade, dollar-denominated debt servicing, and the Treasury market’s role as core collateral. When uncertainty spikes, global institutions still reach for dollar liquidity, even when the US is part of the geopolitical story.
US power projection is increasingly exercised through economic means rather than solely military channels. Trade restrictions, sanctions, and regulatory measures compel both allies and rivals to reassess their exposure to the dollar. While this does not displace the dollar’s dominance, it alters global holding patterns, resulting in greater use of hedging, shorter investment horizons, and heightened sensitivity to policy uncertainty.
A practical example is trade policy uncertainty. Current baseline assumptions for global projections keep the US effective tariff rate around 18.5%, with policy uncertainty assumed to remain high through 2026. Tariffs can strengthen the dollar by raising inflation risk and yields, but they can also weaken it if they damage growth expectations or provoke capital flight from risk assets.
For EURUSD, geopolitics therefore acts like a volatility amplifier. It tends to cap euro rallies during shocks, while also limiting sustained dollar downtrends if markets price a political risk premium into US assets.
The 2026 outlook for the euro is frequently characterized by concerns over fragility, including war risks near European borders, energy insecurity, and political fragmentation. While these risks are significant, 2026 also introduces a counterbalancing factor that foreign exchange markets may underestimate: an increased emphasis on fiscal capacity and strategic investment.
Euro area projections explicitly incorporate additional defence and infrastructure spending, with the largest growth impact expected in 2026 and 2027 and much of the impulse coming through Germany. That matters for the euro because it reduces the region’s chronic underinvestment problem, supports internal demand, and can help narrow the transatlantic growth gap at the margin.
Europe continues to face fiscal constraints. The euro area fiscal balance is projected to be approximately -3.3% of GDP in 2026, with public debt levels rising. (European Central Bank) While this does not represent fiscal strength, it marks a shift away from austerity, and foreign exchange markets are responsive to changes in growth composition and fiscal discipline.
Much of the commentary on EURUSD focuses on the Federal Reserve versus the ECB. In 2026, however, the dynamics of cross-border portfolio flows are likely to play a more influential role.
Covered interest parity ties the spot-forward relationship to the interest rate differential. When US short rates exceed euro short rates, euro-based investors buying US bonds or equities face a larger negative carry if they hedge the currency exposure. This is one reason the dollar can stay strong even when valuation looks stretched.
As the Fed eases and the differential compresses, the cost of hedging dollar exposure falls. Two things can follow:
Europe can buy US assets with less hedging pain, keeping capital flowing into the US without requiring a stronger dollar.
Existing holders can hedge more, which mechanically creates demand for euros in the forward market and can translate into spot support over time.
This perspective is distinctive for 2026, as it suggests that EURUSD can appreciate even if US economic growth remains solid. The euro’s strength does not require a downturn in the US; rather, it depends on a narrowing rate gap and a reduction in the hedging penalty.
| Driver | United States | Euro area | EURUSD implication |
|---|---|---|---|
| Policy rate | 3.50% → 3.75% | 2.00% | Differential still favors USD, but shrinking risk |
| Inflation trend | CPI 2.7% y/y (Dec) | HICP ~2.1% (late 2025) | Less justification for wide real rate gap |
| 2026 growth baseline | ~2.4% | ~1.3% | US growth edge remains, but not overwhelming |
| External balance | Current account deficit 2.9% of GDP (Q3 2025) | Current account surplus 1.7% of GDP (Q2 2025) | Structural support for EUR over time |
| Fiscal pressure | FY2025 deficit 5.9% of GDP; debt ~99.8% of GDP | Budget balance -3.3% of GDP in 2026; debt ~88.1% | Higher US term premium supports USD, but raises confidence risk |
If the Federal Reserve continues to ease policy toward a neutral stance while the ECB remains cautious, EURUSD is likely to trade within a broad $1.12 to $1.20 range for much of 2026. Upside movements may be driven by lower hedging costs and an improving demand mix in Europe. The dollar is expected to outperform during acute risk events, but such rallies may dissipate more quickly than in the 2022 to 2024 period.
A true risk-off environment, triggered by either renewed security tensions in Europe or a global trade shock, generally increases demand for the dollar via funding channels. Under such conditions, EURUSD could decline toward the $1.05 to $1.10 range, even if US interest rates are falling, as liquidity preference outweighs yield considerations.
If US disinflation accelerates and the Federal Reserve reduces rates more rapidly than its median projections, while euro area inflation remains near target and growth is sustained, EURUSD could appreciate toward the $1.20 to $1.25 range. In this scenario, rate convergence and favorable hedging dynamics would reinforce each other.
The US is capable of sustaining large fiscal deficits over extended periods, but confidence shocks can be abrupt and nonlinear. Should markets require a significantly higher term premium to absorb Treasury issuance, the dollar may initially strengthen due to higher yields, but could subsequently weaken if risk assets are repriced and foreign investors seek a greater currency risk buffer. In such a regime, EURUSD is likely to exhibit increased volatility rather than a clear directional trend.
Rate convergence matters, but the bigger swing factor is how geopolitics affects global funding demand. In calm markets, narrowing rate differentials and cheaper hedging can support the euro. In shocks, dollar liquidity demand can overwhelm fundamentals.
The dollar has strong structural support, but it is less likely to trend higher without fresh inflation pressure or a major risk event. If the Fed keeps cutting and inflation cools, the dollar can lose some of its carry advantage, even if US growth stays firmer than Europe’s.
Yes. EURUSD can rise on external balance and portfolio flow mechanics. Europe’s current account position is structurally stronger than the US position, and a smaller rate gap reduces the hedging penalty that has discouraged euro-based investors from holding dollar assets on a hedged basis.
They affect EURUSD through inflation, growth, and confidence channels. Tariffs can lift US inflation risk and keep yields higher, supporting the dollar. But they can also harm growth and raise policy uncertainty, thereby reducing foreign appetite for unhedged dollar exposure.
The market tends to anchor around psychological zones. The $1.10 area often separates stress regimes from stable regimes, while $1.20 tends to require either clear Fed easing, a softer US data cycle, or sustained improvement in European confidence and capital flows.
The outlook for EURUSD in 2026 is shaped less by a singular macroeconomic forecast and more by the interplay of competing premiums: the yield premium that has historically supported the dollar versus the geopolitical and hedging premiums that may limit its upside.
A plausible baseline scenario is a slower and more volatile market in which the dollar relinquishes part of its structural carry advantage as US policy rates approach neutral. Meanwhile, the euro stands to benefit from stable inflation, strengthening domestic demand, and a fiscal policy mix increasingly oriented toward defense and infrastructure investment. The dollar is likely to retain its advantage during periods of acute market stress.
However, barring repeated global deleveraging episodes in 2026, the probability of relative euro strength increases as the interest rate gap narrows and the non-yield costs of holding dollars rise.
Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
