The monetary policies of major central banks may diverge significantly this week, marking a critical turning point for the markets. With strengthened economic resilience, the European Central Bank is facing rising expectations for rate hikes, and its increasingly hawkish stance is supporting the euro's strength; although the Bank of England may cut rates to 3.75%, it remains constrained by a “stagflation” scenario, leaving policy prospects highly uncertain; the Bank of Japan may raise rates as expected to 0.75%, but due to its slow tightening pace, the yen remains persistently weak, with carry trades continuing to dominate the currency market. Meanwhile, the dollar awaits guidance from non-farm payroll data.
I. The European Central Bank 'shifts from dovish to hawkish,' reversing market expectations
The market was previously discussing when the European Central Bank would begin a rate-cutting cycle, with some even predicting potential rate cuts by the end of 2025 or in 2026. However, this expectation has now been overturned. Analysts widely believe that even at the final interest rate meeting in 2025, the European Central Bank will not adjust the current benchmark rate of 2%, and this high-interest-rate environment is likely to persist until 2027. More surprisingly, market expectations for rate hikes are rapidly increasing — the probability of a rate hike within the next year has surged from 30% to 60%.
This shift is not without foundation. Recently released economic data indicate that the Eurozone economy is demonstrating stronger-than-expected resilience. December’s preliminary PMI figures showed that both manufacturing and service sector sentiment exceeded expectations, suggesting that the economic fundamentals have not weakened as previously feared. At the same time, there have been repeated strong signals from within the European Central Bank. Governing Council member Isabel Schnabel clearly stated that the current easing cycle has ended, and the next policy move is more likely to be a rate hike rather than further easing. Although formal discussions on rate hikes have not yet commenced, Lagarde has already hinted that economic growth forecasts will be raised at this week’s meeting, undoubtedly setting a positive tone for the gathering.
Against this backdrop, the transatlantic interest rate differential is narrowing quickly, making euro assets an increasingly attractive alternative to the dollar. The strengthening short-term interest rate advantage is driving the euro higher. Analysts pointed out that if subsequent data continue to support the growth narrative, the euro could appreciate further in the medium term, becoming a key variable in global capital reallocation.
II. The UK trapped in a 'stagflation dilemma,' with rate cuts becoming a contentious issue
In stark contrast to the firm stance of the European Central Bank, the Bank of England is grappling with unprecedented decision-making challenges. Over the past seven months, the economy contracted month-on-month in six months, unemployment has been rising, and the job market continues to lose positions, indicating a significant loss of momentum. Logically, such conditions should prompt the central bank to decisively cut rates to stimulate the economy. However, the reality is far more complex — inflationary pressures remain stubbornly high, with core inflation significantly above the 2% target, ranking highest among G7 countries.
This “stagnant growth, high prices” stagflation scenario has placed monetary policy in a dilemma. Rate cuts could exacerbate the risk of an inflation rebound, while maintaining rates does little to rescue the sluggish economy. Markets generally expect that the Bank of England will lower the benchmark rate from 4% to 3.75% this Thursday (December 18). However, this decision is not set in stone. Analysis by Bank of America suggests that the Monetary Policy Committee may face a 5-to-4 voting split, highlighting the intense tug-of-war between hawks and doves.
Governor Bailey and his team are expected to emphasize that any subsequent actions will proceed in a “gradual and prudent” manner, without pre-committing to a specific path. This statement serves both as a warning against over-betting on consecutive rate cuts and as a necessary strategic ambiguity amid rising data uncertainty. In fact, recent data paint a contradictory picture: the labor market continues to deteriorate, corporate hiring demand is shrinking, and wage growth is slowing; however, service price stickiness remains strong, and the path of disinflation is not smooth. Therefore, even if this rate cut materializes, significant doubts remain about whether the UK can sustain an easing cycle. Unless inflation shows a clear and sustained downward trend, further room for easing will be extremely limited.
III. Japan takes its first step toward tightening — why isn’t the yen strengthening?
The Bank of Japan is almost certain to raise the overnight call rate to 0.75% this week, marking another key step toward the normalization of monetary policy following the termination of a decade-long negative interest rate policy earlier this year. However, the market reaction has been unusually subdued—traders have not responded by purchasing the yen.
The reason lies in the fact that although the Bank of Japan has technically embarked on a tightening process, the overall pace is still widely regarded as extremely slow. The market believes that the Bank of Japan will maintain a cautious stance over the long term, avoiding any rapid tightening that could undermine the already fragile economic recovery or trigger financial market turbulence. Additionally, the yen's status as a traditional funding currency has not fundamentally changed. Due to the significant interest rate differential between the US and Japan, carry trades remain active. A substantial amount of capital continues to borrow low-interest-rate yen to invest in higher-yielding assets, particularly US Treasury bonds and overseas markets.
Under this structural environment, even a modest interest rate hike by the Bank of Japan is unlikely to reverse the long-term weakening trend of the yen. On the contrary, each rate hike may provide more room for carry trades, further suppressing the performance of the yen. Analysts noted that unless the Bank of Japan demonstrates a stronger signal of policy shift or US interest rates enter a clear downward trajectory, the yen will have little chance of a substantive reversal.
IV. The US Dollar Awaits Non-Farm Payroll Guidance
Amid diverging global central bank policies, the US dollar is at a critical juncture for directional choice. The November non-farm payroll data to be released this week has become the focal point. Experts predict that only 50,000 new jobs will be added, with the unemployment rate remaining at 4.4%, the highest level since 2021. If the actual data aligns with expectations, it indicates that the US labor market is indeed cooling, giving the Federal Reserve sufficient reason to pause further rate cuts, at least until March or April next year for reassessment. The futures market has already started pricing this in, reflecting a recalibration of expectations regarding future policy adjustments.
However, more concerning than economic data is the potential erosion of monetary policy independence by political forces. Trump recently publicly called for lower interest rates, suggesting they should be reduced to 1% or even lower to alleviate government debt burdens. He also argued that the next Federal Reserve Chair should consult with him on decisions, emulating past “cooperative models.” Such statements have sparked widespread concerns in the market about the erosion of the Federal Reserve’s independence. Reports also revealed that the White House is attempting to increase the proportion of “dovish” members on the Federal Open Market Committee (FOMC). By the 2026 rotation period, hawkish figures such as Austin Goolsbee and Jeff Schmid will lose their voting rights, objectively creating conditions for a policy shift.
