News & Analysis

An oldie but a goodie – Why central bank differentials still work

3 July 2024 By Evan Lucas


2024 continues to be an interesting year for FX. Even more now that the starters gun has been fired with the European Central Bank (ECB) and Bank of Canada as well as the likes of the Riksbank and SNB all starting to their respective cash rates from COVID peaks.

This brings us to the next stage – who is next, who is going the other way and where does that leave pairs and crosses?

Well let’s start with the biggest gorilla in the pack 

The US Federal Reserve. 

We have to start here because the US dollar at the moment is in an interesting conundrum: it has dovish to neutral leaning central policy which in theory overtime should put a downward trajectory in the dollar, but has been holding or moving to the upside against majors as its investment outlook rights and overall attractiveness outweighs the negative bias of a dovish position.

The question also remains how Darvish is the outlook for rate cuts from the US Federal Reserve? 

Markets have a bias for the Fed to start rate cuts in September with 18 basis points. That equates to about a 68% to 71% chance. May’s softer core PCE inflation data that dropped last week supports the likelihood of cuts due to slowing inflation. Core PCE inflation came in at  0.08% month on month, well below the expected 0.15%. The faster decline was due to lesser-known components, such as non-profit prices and imputed financial services which have now slid for three consecutive months (something we would like to see in Australia) should encourage Fed officials. 

But the market has been hesitant to react to the PCE why? 

Clearly the Fed’s language and actions of late suggest it needs more evidence of easing inflation is sustained. This could be achieved with another favourable read for the June numbers which are due out at the end of this month. We also note that revisions to April’s core PCE were modest (were revised up), and May’s weaker data might indicate a positive trend in Q2. Remember this is the Fed core measure of inflation and needs it to be at or around 2%.

Dollar Basket

Yet once again we come back to the USD – its lower compared to pre-PCE trading but not by a margin that gives confidence the Fed is going to cut rates in the coming months.

Which suggests we need to break out the pairs and look more directly at actions.


If you look at EUR/USD, the biggest player in the DXY, the easing bias from the Fed is there. Not only that since the ECB cut rates last month there has been a growing belief the Board will hold off to see the reactions across the zone before acting again. Inflation in the likes of Germany, France and Italy are so varied it hard to get a proper read on the overall composition of the eurozone which is going to make it very hard for the ECB and its board’s decision making. Explains why the initial decrease in the euro has subsided. We also can’t write off the elections that are going on inside France right now. The rise of the far right nationalistic protectionism parties clearly also is a threat to the eurozone and therefore the euro itself.

However with that in mind if you look at the central bank differentials between the ECB and the US Federal Reserve. It is clear that there is more of a dovish bias from the Fed (as they should be) and it’s more likely the Fed is going to move next rather than the ECB.

Listening to Fed talkers  like Governor Cook who expects cuts soon. Then there are the doves like San Francisco Fed President Mary Daly that are razer focused on unemployment. She described the risk that “future labour market slowing could translate into higher unemployment, as firms need to adjust not just vacancies but actual jobs.” She stated that past tolerance of high unemployment to curb inflation like that in the 1970 and 1980 was not tolerable – suggesting that inflation is not the only trigger there. Governor Cook downplayed recent strong job growth, citing overstated payroll gains and a slower true pace of job gains. Weak labour data this Friday (non-farm payrolls) could signal rate cuts at the July FOMC meeting. On the NPF the consensus is for a slower 155,000 increase for the month of June. The unemployment rate is projected to stay at 4.0%, and average hourly earnings should rise by 0.4%  month on month. 

The Fed’s June meeting minutes this week will likely show higher 2024 rate cut projections, with officials needing more data to be confident in sustained inflation reduction. 

In short, USD data is forecasted to be bearish. So it’s about choosing your pairs wisely and clearly things like EUR, GBP, CAD etc. are difficult to deal with currently as each is facing a bearish issue of their own.

Thus let us finish on a differential that is clear – the RBA versus the Fed and the Bank of Japan. 


Although AUD/USD hasn’t completely broken out of its 0.661 to 0.669 range. The slow uptrend momentum is building. The test as we described last week is the July 31 CPI print. The minutes from the last RBA meeting were telling – there are only two options on the table, hold or hike and the argument for a hike was well made and without the May monthly inflation read. A print above 3.9% August 6 is basically a lock putting the RBA out of sync with the rest of the G10. The differential here is glaring and one of the most bullish signals for the AUD. We watch the AUD/USD for signals that uptrend is on.

Which brings us to the final cross to discuss. AUD/JPY

The trend is clear and the different responses between the BoJ and the RBA couldn’t be starker. The BoJ has lost control of its currency and is unable to provide stability. The pressure it’s experiencing is real and with next to no inflation Japan is facing a difficult situation of dealing with capital outflows while needing to be accommodative. 

Count that with the RBA that has the highest cash rate in 12 years, highly attractive yields and. The possibility of further increases – cash inflows are glaring. The cross has been capping out at Y107.5 but once again July 31 is key – inflation signalling rate hikes and AUD/JPY will be chasing Y108 and beyond.

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