Central Banks Diverging: What 2026's Rate Trajectory Could Mean for EUR/USD

The currency market is bracing for a year of policy divergence. While the Federal Reserve has already delivered three rate cuts in 2025 and signals more could follow, the European Central Bank remains in holding pattern, with its deposit rate locked at 2.00% since July. That interest rate gap—and how it evolves—will be the defining factor for EUR/USD in 2026. But it’s not just about the numbers; it’s about what drives them.

Europe’s Growth Engine: Sputtering, Not Stalling

The Eurozone’s economic momentum has lost steam, and the problem runs deeper than cyclical weakness. Germany’s automotive sector, grappling with the shift to electric vehicles and supply chain friction, has seen output decline by 5%. Innovation investment gaps have left European tech capabilities trailing both the US and China in critical sectors. On top of that, trade barriers are re-entering the conversation—the incoming US administration’s “reciprocal tariff” framework poses a real risk. Reports suggest EU goods could face 10%–20% tariffs, a structural headwind for export-oriented economies. Early data shows EU exports to the US down 3%, with autos and chemicals bearing the brunt.

The European Commission’s latest projections tell a cautious story: 1.3% growth for 2025, a softer 1.2% for 2026, and a rebound to 1.4% in 2027. The downward revision for 2026 signals that policymakers expect a bumpier ride ahead. Regional performance remains uneven—Spain and France posted 0.6% and 0.5% quarterly growth respectively in Q3, while Germany and Italy stalled at 0% (flat). The headline reads as sluggish, but there’s an important subtext: the economy isn’t breaking, just limping along.

Inflation: The ECB’s Hidden Brake on Rate Cuts

Price pressures have stopped declining neatly toward the ECB’s 2% target. As of November, Eurozone inflation stood at 2.2% year-on-year, edging above the bank’s medium-term objective. The composition is what matters most: while energy prices dipped 0.5%, services inflation climbed to 3.5%, up from 3.4% in October. Services-sector price stickiness is precisely what central banks dread—it signals the disinflation process may be losing steam.

This backdrop explains why the ECB held all three benchmark rates steady in December. The deposit facility, main refinancing rate, and marginal lending facility remained at 2.00%, 2.15%, and 2.40% respectively. ECB President Christine Lagarde’s post-meeting comments—describing policy as in a “good place”—projected no urgency for near-term action. Market consensus aligns: most economists polled by Reuters expect rates to stay unchanged throughout 2026 and 2027, though confidence clearly weakens as the forecast horizon extends. A late-2026 or early-2027 hike is viewed as more probable than cuts if any move occurs.

The Fed’s 2026 Question: How Far Will Cuts Go?

The Federal Reserve surprised markets by cutting three times in 2025, exceeding its own December 2024 projection of two moves. After holding steady in March (concerned about tariff-driven inflation), the Fed found room to cut in September, October, and December, bringing the federal funds target down to 3.5%–3.75%. The tailwind: softening inflation data and weakening labor market indicators opened the policy window.

Political dynamics add a wild card. Jerome Powell’s tenure concludes in May 2026, and reappointment is considered unlikely. Trump has publicly criticized Powell for moving cautiously on cuts and has signaled the next Fed chair would embrace faster easing. The incoming administration is expected to unveil its Fed leadership choice in early January.

Goldman Sachs, Morgan Stanley, Bank of America, Wells Fargo, Nomura, and Barclays have all lined up on a similar forecast: two rate cuts in 2026, bringing policy to 3.00%–3.25%. Goldman targets March and June for those cuts; Nomura sees June and September. The reasoning isn’t bullish growth expectations—it’s the opposite. Economists expect the economy to remain stuck in a delicate equilibrium, neither accelerating nor contracting sharply.

EUR/USD in 2026: Two Competing Narratives

The euro’s direction hinges on a binary question: Will Europe’s growth stay resilient enough to justify the ECB’s patience, or will weakness force the central bank’s hand into rate cuts?

Scenario A: Growth holds above 1.3% and inflation drifts higher

If the Eurozone avoids a sharp slowdown and price pressures persist, the ECB maintains its hold-steady stance. With the Fed cutting and the ECB static, the yield differential narrows in favor of the dollar, but the euro doesn’t get hammered. This supports EUR/USD poking above 1.20—potentially testing 1.21–1.22.

Scenario B: Growth undershoots to below 1.3% and trade shocks bite

If Eurozone growth disappoints and trade friction accelerates, the ECB may feel compelled to ease alongside weakening activity. The rate gap widens in the Fed’s favor, and EUR/USD retreats toward 1.13. In a severe downside case, 1.10 becomes plausible.

What the Forecasts Reveal

The divergence among major banks reflects uncertainty baked into the underlying assumptions:

Citi’s bearish take: Expecting EUR/USD to hit 1.10 by Q3 2026. The thesis: US growth re-accelerates while Fed cuts disappoint expectations, and Europe stalls. This represents roughly a 6% move lower from current 1.1650 levels.

UBS’s constructive view: Targeting EUR/USD at 1.20 by mid-2026. UBS argues that if the ECB holds firm while the Fed continues cutting, the yield curve advantage shifts toward the euro, supporting appreciation.

The range—1.10 to 1.20—brackets the realistic outcomes. Which one wins depends on which story plays out: a “Fed cuts + Europe muddles through” script favors higher EUR/USD, while a “Europe slows + trade escalates + ECB eases” script keeps upside capped and plays toward 1.13 or lower.

The Bottom Line for 2026

The outlook meaning for EUR/USD traders is straightforward: policy divergence will dominate. The Fed’s apparent willingness to cut more aggressively (whether driven by growth softness or political pressure) versus the ECB’s patient hold creates a natural pressure on the euro. But Europe’s capacity to avoid recession—and keep inflation sticky enough to justify the ECB’s caution—remains the swing factor. Watch Eurozone growth data, services inflation prints, and any signals from Lagarde’s commentary. If either deteriorates sharply, EUR/USD’s floor could test lower levels quickly. If Europe’s resilience persists, the euro has room to surprise upside.