Euro and Pound Outlook Through 2026: Policy Divergence Today, Convergence Tomorrow
- admin cys
- Aug 27
- 4 min read
A Report by CYS Global Remit Counterparty Sales & Alliance Unit
Euro: Constructive but Capped—Why BofA and UBS See Upside with Limits
Both Bank of America (BofA) and UBS expect the euro to firm against the U.S. dollar into 2026, but for different mixes of reasons—and with a shared view that gains are not unlimited. BofA frames the near-term setup as a “lower bar for upside Europe/Germany surprises,” arguing that recent developments have depressed expectations enough that moderately better data could lift the euro. That view underpins their constructive stance on EUR versus the Japanese yen, U.S. dollar, and Swiss franc, even as they stay neutral to bearish on other G10 crosses such as EUR/GBP and EUR/AUD. In short: selective euro strength, not a blanket rally.
Policy divergence anchors BofA’s case. The European Central Bank (ECB) retains flexibility to add stimulus as needed, whereas the Federal Reserve is juggling tougher “stag-flationary trade-offs.” When one central bank can cut, tweak liquidity tools, or lean into targeted credit support while the other hesitates, relative growth expectations can tilt. BofA’s read is that this contrast—ECB flexibility versus Fed constraints—supports EUR on key pairs like EUR/USD, EUR/JPY, and EUR/CHF. They also point to sentiment: BofA’s August 8 and August 11 surveys indicate investors still price “meaningful implementation risks to German fiscal and European defence spending” after the recent U.S.-EU trade deal. Paradoxically, that caution lowers the hurdle for upside surprises if fiscal measures materialize more smoothly than feared. Meanwhile, BofA notes that fiscal expectations in Europe compare favourably with market concerns over the U.S., Japan, and the U.K., potentially adding incremental support to the single currency.
UBS broadly agrees on direction but adds a medium-term cap. They see EUR/USD strengthening toward fair value— “around 1.25”—but “not materially above.” Their forecast path reflects three overlapping dynamics. First, they expect the Fed to resume rate cuts in September 2025 and guide the policy rate toward roughly 3% by April 2026. That easing phase is initially dollar-negative. Second, UBS anticipates that the U.S. trade war, a dominant narrative in 2025, fades by mid-2026 as domestic policy and the midterm cycle refocus attention on U.S. growth, reducing the shock premium that has supported the dollar. Third, as Europe’s fiscal support gains traction—highlighted by Germany’s fiscal package and stepped-up European defence spending—European indicators should “close the gap” with U.S. data into mid-2026.
Yet these same forces imply a ceiling. As the Fed’s easing cycle matures and other central banks approach neutral, policy divergence becomes less powerful as a driver. With cross-market rate differentials stabilizing, the euro’s incremental tailwind weakens. UBS therefore extends a 1.23 EUR/USD target into 3Q26 and reiterates the idea of a peak near 1.25. Practical translation: upside exists, but late-cycle convergence in policy and growth argues against a runaway euro.
Risks to the euro are two-sided. On one end, better-than-expected European implementation of fiscal measures—particularly in Germany—could generate positive growth surprises and push EUR toward the top of UBS’s range sooner. On the other, lingering trade policy uncertainty, energy cost volatility, and the U.S. fiscal debate could swing risk sentiment abruptly. UBS flags the U.S. fiscal deficit as a key challenge to exchange-rate stability in late 2026, a wildcard that could either undermine or, if addressed credibly, support the dollar. For portfolio construction, this argues for measured euro exposure—favouring EUR versus JPY, USD, and CHF as BofA suggests—while respecting the 1.25 “cap” logic and being selective on crosses like EUR/GBP and EUR/AUD where BofA remains cautious.
Pound: Rate Profile and Carry Appeal Support a Grind Higher—But with Checkpoints
UBS sees the British pound continuing its uptrend against the dollar, projecting GBP/USD at 1.40 by September 2026 and 1.39 into year-end 2025 and March 2026. The pair has already clawed back its July dip and re-established the 1.35 handle, with the bank highlighting 1.33 as a major support area and 1.38 as a resistance level likely to give way later this year. The logic combines domestic policy, inflation dynamics, and carry appeal.
Start with the Bank of England (BoE). Markets interpreted the latest BoE meeting as hawkish, and July inflation reinforced that stance. UBS expects the BoE to cut only on a quarterly cadence, reflecting sticky inflation pressures. That slow-easing profile leaves the pound comparatively high-yielding within the G10— “a leading carry trade candidate,” in UBS’s phrasing—especially as the Fed proceeds deeper into its own easing cycle. Rate differentials aren’t everything, but they matter more when global growth is decent, and volatility is not extreme. In that environment, carry-seeking flows can provide a persistent bid for GBP, helping the pair test and eventually break the 1.38 resistance.
The dollar side of the equation also helps. UBS expects broad USD softness over the remainder of the year amid prospects for lower Fed policy rates, policy uncertainty from the White House, a new U.S. fiscal package, and a shift by international investors toward higher hedge ratios on dollar assets. Each of these marginally reduces the dollar’s “carry and safety” advantages, allowing pro-growth currencies with supportive rate profiles—like GBP—to outperform in risk-on phases.
Still, UBS is careful to mark the risk boundaries. A more protracted loosening of the U.K. labour market or a faster-than-expected disinflation path would embolden the BoE to cut faster, narrowing the pound’s carry edge. Domestic fiscal worries could also unsettle sterling if investors demand higher premia to hold U.K. assets. And, as always, a more hawkish-than-anticipated Fed—should U.S. data reaccelerate, or inflation prove stubborn—would bolster the dollar and cap GBP/USD upside. That is why UBS pairs its constructive trajectory with clearly defined technical “checkpoints”: support near 1.33 to watch on dips, resistance around 1.38 to gauge the uptrend’s strength, and a medium-term objective of 1.40 by September 2026.
Putting it together, the euro and pound share a constructive, not euphoric, outlook versus the dollar. The euro benefits from ECB flexibility, stabilizing European fiscal prospects, and a lower bar for positive surprises—yet likely tops out near 1.25 as global policy settings converge. The pound’s case leans more on its carry profile and the BoE’s gradualism, with technical levels providing waypoints on a path toward 1.40 by late 2026.
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