2026 Euro Outlook: How Policy Divergence Could Reshape EUR/USD Dynamics

The divergence between monetary authorities on opposite sides of the Atlantic is set to be a defining driver for currency markets in 2026. While the Federal Reserve has already shifted into an easing cycle—completing three reductions since September—the European Central Bank remains in holding mode, with rates locked at 2.15% since mid-year. This policy gap will be pivotal in determining whether the euro advances toward 1.20 or retreats closer to 1.13 and beyond.

The Eurozone’s Growth Challenge: Resilient but Uneven

Europe’s economic momentum tells a complicated story. Growth remains present but constrained, expanding at a measured 0.2% in Q3 across the eurozone, though with stark divergence: Spain and France delivered 0.6% and 0.5% respectively, while Germany and Italy stalled. The European Commission’s baseline projection frames a gradual deceleration, forecasting 1.3% growth for 2025, a softer 1.2% for 2026, and a rebound to 1.4% in 2027—a pattern suggesting next year may prove choppier than consensus currently prices.

Structural headwinds add weight to cyclical concerns. Germany’s automotive sector faces a 5% output contraction amid the electric vehicle transition and ongoing supply disruptions. Meanwhile, Europe’s innovation gap versus the US and China persists due to chronic underinvestment in emerging technologies.

Trade dynamics have turned troublesome. The prospect of reciprocal tariffs ranging from 10-20% on EU exports to America threatens to inflict real damage on export-dependent economies. Early indicators already point to a 3% decline in EU shipments to the US, with chemicals and automobiles absorbing the heaviest blows. These cross-currents mean eurozone resilience shouldn’t be confused with momentum—the economy is muddling through rather than accelerating.

Inflation Resurgence: The Reason the ECB Won’t Budge

Just as deflation risks appeared to fade, price pressures are reasserting themselves. Eurozone inflation reached 2.2% year-on-year in November, edging above the ECB’s 2.0% medium-term anchor and climbing from 2.1% the prior month. The composition is particularly concerning for policymakers: while energy prices declined 0.5%, services inflation climbed to 3.5% from 3.4%, exactly the sticky category central banks struggle to contain.

On December 18, the ECB predictably held all rates steady—the deposit facility at 2.00%, the main refinancing rate at 2.15%, and the marginal lending facility at 2.40%. With cuts paused through the second half of 2025 and inflation projections suggesting a gradual descent over three years, the consensus view among analysts and ECB watchers points to a prolonged pause: neither cutting nor hiking appears imminent. President Lagarde’s post-meeting characterization of policy as being in a “good place” reinforced the absence of urgency.

Market analysts align with this assessment. Union Investment’s Christian Kopf sees no near-term movement, with any policy shift more likely arriving in late 2026 or 2027—if anything, tilted toward tightening. A Reuters economist survey echoes this sentiment, with most respondents expecting unchanged rates throughout 2026 and into 2027, though confidence erodes sharply beyond the immediate horizon.

The Fed’s Easing Trajectory: Politics and Economics Collide

The Federal Reserve’s 2025 proved more dovish than initially signaled. Three rate reductions brought the federal funds target to 3.5%-3.75%, exceeding the December 2024 projection of two cuts. A March pause—attributable to tariff concerns and disinflation worries—gave way to September’s initial cut, followed by moves in October and December as inflation cooled and labor conditions softened.

Looking ahead, political considerations inject additional complexity. Jerome Powell’s tenure concludes in May 2026, with reappointment widely deemed unlikely. Trump’s public criticism of Powell’s “slowness” on cuts and hints that his Fed successor would embrace faster easing add a layer of uncertainty. Major investment banks have aligned on expectations of two cuts in 2026, potentially reaching 3.00%-3.25%—though the rationale matters as much as the prediction. Rather than an overheating economy necessitating rate support, these cuts would address a growth scenario Moody’s characterizes as “delicate balance.”

Goldman Sachs and Nomura pencil in multiple scenarios, with cuts potentially arriving in March-June or June-September windows, reflecting the genuine uncertainty embedded in forecasts stretching twelve months forward.

EUR/USD in 2026: Mapping Two Competing Narratives

The path for euro-dollar exchange rates hinges on two foundational variables: whether eurozone growth remains above or below 1.3%, and whether the ECB’s patience translates into resilience or becomes a liability if deterioration accelerates.

Scenario One: Steady Europe, Persistent Fed Cuts

If eurozone expansion holds above 1.3% and inflation edges toward target gradually, the ECB can maintain its hands-off approach. Simultaneously, if Fed cuts continue materializing without economic collapse, the interest rate differential narrows—a dynamic historically supportive of the euro. In this environment, EUR/USD could easily move above 1.20, with some forecasters eyeing even more ambitious targets. For context, if euro strengthens significantly, valuations around 70 euro to USD conversion rates become increasingly relevant for hedging and portfolio allocation decisions.

Scenario Two: Growth Shock, ECB Forced to Act

Conversely, if eurozone GDP growth disappoints and dips below 1.3%, the ECB faces mounting pressure to shift from neutral to supportive. Preemptive rate cuts would materialize, likely pulling EUR/USD back toward the 1.13 support zone and potentially challenging the 1.10 floor. Trade war escalation accelerating this deterioration would only hasten the euro’s retreat.

Institutional Forecasts Paint Opposing Pictures

Citi’s base case envisions dollar strength reasserting dominance, with USD purchasing power climbing such that one euro fetches just $1.10 by Q3 2026—implying roughly 6% depreciation from current 1.1650 levels. This projection rests on US growth re-accelerating while Fed cuts disappoint relative to market pricing.

UBS Global Wealth Management advances a contrasting thesis: ECB hold + Fed cuts = narrowing yield differential = euro support. Their mid-2026 target sits at 1.20, reflecting confidence in eurozone resilience and Fed follow-through on rate reductions.

The 2026 euro outlook ultimately resolves into a binary question: if policy divergence widens (Fed easing vs. ECB patience) while Europe avoids recession, the euro has room to climb. If trade shocks bite harder, growth falters, and the ECB shifts to damage control, then 1.13 and 1.10 transition from theoretical to increasingly probable price targets.