2026 EUR/USD Trajectory: Why the Rate Differential—and What Drives It—Could Reshape Euro Dynamics

The euro’s performance next year hinges on a simple but crucial asymmetry: if the Federal Reserve continues easing while the ECB remains on hold, the currency’s next move depends less on the raw rate gap and more on whether Europe’s growth story holds up under trade pressure. That tension—between Fed dovishness and ECB patience—is the real variable that will determine if EUR/USD trades toward 1.20 or slides back toward 1.10.

The Fed is already cutting; the ECB isn’t budging

The divergence between the two central banks is already baked into 2026 expectations. The Federal Reserve has delivered three rate cuts since September, bringing its target range to 3.5%–3.75%. Meanwhile, the ECB has held its main refinancing rate steady at 2.15% since July, signaling it’s content to watch and wait. That 135 basis point spread is already pricing in a difference in policy urgency—but the real question is whether it widens or narrows over the coming year.

Fed expectations for 2026 lean toward additional easing. Major banks including Goldman Sachs, Morgan Stanley, Bank of America, and Wells Fargo are modeling two rate cuts in the year ahead, which would take the federal funds range down toward 3.00%–3.25%. Some forecasters, like Moody’s chief economist Mark Zandi, expect multiple cuts—though not because the US economy is booming, but because it’s navigating a delicate balance. Political uncertainty adds another layer: Jerome Powell’s term as Fed chair expires in May 2026, and while his replacement isn’t yet confirmed, the incoming administration has signaled it prefers a more dovish approach to monetary policy.

The ECB, by contrast, isn’t in a rush either way. With inflation at 2.2% year-on-year in November (above the ECB’s 2.0% target) and services inflation particularly sticky at 3.5%, the bank has little reason to cut. Simultaneously, with eurozone growth running at just 1.2%–1.3% projected for 2026, there’s also little urgency to hike. ECB President Christine Lagarde described policy as being in a “good place” after the December meeting, essentially signaling the bank will sit tight. Reuters surveys show most economists expect the ECB to hold rates unchanged through 2026 and into 2027—a baseline that’s unlikely to shift unless either growth collapses or inflation re-accelerates sharply.

Europe’s growth picture: weak but not broken

Underneath the euro’s relative stability lies a mixed economic reality. Eurozone growth is definitely slowing—the commission’s autumn outlook projects just 1.2% expansion in 2026, down from 1.3% in 2025—but it’s not collapsing. That distinction matters for currency markets, because a stagnating Europe would likely force ECB action, which would undermine the euro. A merely sluggish Europe can hold its own.

The headwinds are real. Germany’s auto sector—traditionally Europe’s growth engine—has contracted 5% as the industry grapples with the EV transition and supply-chain volatility. Innovation underinvestment has left Europe trailing the US and China in key technology segments. And now trade policy is emerging as a new risk: the Trump administration’s reciprocal tariff framework is raising the threat of 10%–20% levies on EU goods, with autos and chemicals bearing the brunt. EU exports to the US are expected to decline roughly 3%, a meaningful hit to export-dependent economies.

Yet within this softer backdrop, resilience is visible. In Q3, Spain and France posted quarterly growth of 0.6% and 0.5% respectively, while the eurozone as a whole expanded 0.2%. It’s slow, not stalled—a distinction that keeps the euro from looking fundamentally broken and provides at least a baseline for the ECB to hold ground.

The rate gap narrative: how exchange rates actually respond

Here’s where the “rate differential” story gets more nuanced. Yes, a wider gap between Fed and ECB rates should in theory push the dollar higher and the euro lower. But currency markets trade narratives as much as they trade numbers, and the reason why that gap widens—or narrows—shapes trader behavior.

If 2026 unfolds as “Fed cuts + Europe muddles through,” the yield differential narrows but the narrative around growth divergence remains stable. In that scenario, EUR/USD could actually push higher toward 1.20, because the market perceives Fed easing as confidence-building rather than crisis-driven, while Europe’s slower pace doesn’t signal desperation.

Conversely, if growth disappoints—if the trade shock bites harder than expected and the ECB signals it might cut to support activity—then the narrative flips. The rate gap narrows not because the Fed is relaxed, but because the ECB is forced into accommodation mode. That’s a genuinely different story, one that historically undermines the euro and could pull EUR/USD back toward 1.13 or even 1.10.

Where the major forecasters stand

The institutional outlook splits sharply, and the splits reveal how much assumptions matter:

Citi’s base case: The dollar strengthens. With US growth re-accelerating and the Fed cutting less than markets currently expect, Citi projects EUR/USD at 1.10 by Q3 2026—roughly a 6% decline from current levels. This view assumes trade tensions escalate and Europe’s growth stumbles, forcing policy divergence that favors the dollar.

UBS’s alternative: The euro holds firm to rises. If the ECB stays on hold while the Fed continues its cutting cycle, the yield gap narrows but it does so from a position of stable growth expectations. UBS Global Wealth Management expects EUR/USD to trade toward 1.20 by mid-2026, betting that narrowing yields in a risk-resilient environment support the euro.

The consensus lean: Two cuts from the Fed in 2026 (Goldman Sachs timing: March and June; Nomura: June and September) combined with an ECB hold would theoretically flatten the rate curve but keep it favoring the dollar. Yet that conclusion depends entirely on whether Europe’s 1.2% growth forecast holds or cracks under trade pressure.

The trading reality: two paths, one decision point

For investors watching EUR/USD through 2026, the setup comes down to this: the euro’s resilience depends not on rate cuts alone but on whether Europe’s modest growth can withstand trade shock without triggering ECB capitulation. If the eurozone economy holds up and inflation stays manageable, the bank stays patient, and the euro has room to appreciate toward 1.20 even as the Fed cuts. If growth deteriorates and services inflation continues to creep up—forcing an ECB pivot toward easing—then 1.13 becomes the new support zone, with 1.10 no longer theoretical.

The rate differential will matter, but it won’t be the whole story. The real edge in 2026 belongs to traders who can read whether Europe’s “weak but not broken” growth story stays intact or fractures when 2026’s trade headwinds arrive.