Major central bank monetary policies may diverge significantly this week, marking a crucial turning point for the market. The European Central Bank (ECB) is seeing increased interest rate hike expectations due to stronger economic resilience, and its increasingly hawkish stance is supporting a stronger euro. While the Bank of England may cut rates to 3.75%, its policy outlook remains uncertain due to stagflation. The Bank of Japan (BOJ) may raise rates to 0.75% as expected, but the slow pace of tightening and continued yen weakness mean carry trades still dominate the currency market. Meanwhile, the US dollar awaits guidance from non-farm payroll data.

I. The European Central Bank shifts from dovish to hawkish, reversing market expectations.

The market was initially debating when the European Central Bank (ECB) would begin its rate-cutting cycle, with some even predicting a rate cut as early as the end of 2025 or 2026. However, this expectation has now been overturned. Analysts generally believe that even at its final policy meeting in 2025, the ECB will not change the current benchmark interest rate of 2%, and this high interest rate level is likely to remain in place until 2027. Even more surprisingly, market expectations for a rate hike are rising sharply – the probability of a rate hike within the next year has surged from 30% to 60%.

This shift is not without reason. Recent economic data shows that the Eurozone economy has demonstrated greater resilience than expected. Preliminary December PMI figures showed that both manufacturing and service sector activity exceeded expectations, indicating that the economic fundamentals have not weakened as previously feared. Meanwhile, the European Central Bank (ECB) has been sending hawkish signals. Governing Council member Isabelle Schnabel explicitly stated that the current easing cycle has ended, and the next policy move is more likely to be an interest rate hike than further easing. Although discussions on interest rate hikes have not yet formally begun, Lagarde has already indicated that the ECB will raise its economic growth forecast at this week's meeting, undoubtedly setting a positive tone for the meeting.

Against this backdrop, the transatlantic interest rate differential has narrowed rapidly, making euro assets a more attractive asset allocation option than the US dollar. The strengthening of the short-term interest rate advantage has driven the euro's continued appreciation. Analysts point out that if subsequent data continues to support the growth narrative, the euro is expected to rise further in the medium term, becoming a key variable in the global capital reallocation.

II. Britain is mired in a "stagflation dilemma," and interest rate cuts have become a hot potato.

In stark contrast to the European Central Bank's firm stance, the Bank of England is facing an unprecedented decision-making dilemma. For six of the past seven months, the economy has contracted month-on-month, unemployment has continued to rise, the job market has seen persistent job losses, and overall momentum has clearly weakened. Logically, such an environment should prompt the central bank to decisively cut interest rates to stimulate the economy. However, the reality is far more complex—inflationary pressures remain stubborn, with core inflation well above the 2% target, even ranking first among G7 countries.

This stagflationary situation of "stagnant growth and high prices" has put monetary policy in a dilemma. Cutting interest rates could exacerbate the risk of a rebound in inflation, while not cutting rates would hardly revive the sluggish economy. The market widely expects the Bank of England to lower its benchmark interest rate from 4% to 3.75% this Thursday (December 18th). However, this is not a done deal. Bank of America analysis points out that the Monetary Policy Committee may be divided 5-4, indicating a fierce struggle between hawks and doves.

Governor Bailey and his team are expected to emphasize that any subsequent actions will be taken in a "gradual and prudent" manner, without pre-setting a path. This statement serves both as a warning against excessive speculation on consecutive rate cuts and as a necessary strategic buffer in the face of rising data uncertainty. In fact, recent data paints a contradictory picture: the labor market continues to deteriorate, with shrinking demand for labor and slower wage growth; however, service prices are sticky, and the downward path of inflation is not smooth. Therefore, even if this rate cut is implemented, the market remains highly skeptical about whether the UK can continue its easing cycle. Unless inflation shows a clear and sustained downward trend, the room for further easing is extremely limited.

III. Why is the yen not appreciating despite Japan taking its first step toward austerity?

The Bank of Japan is almost certain to raise its overnight call rate to 0.75% this week, a key step toward normalizing monetary policy following the end of a decade-long negative interest rate policy earlier this year. However, the market reaction has been unusually muted – traders have not bought yen as a result.

The reason is that although the Bank of Japan has technically initiated 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 for a long time to avoid damaging the already fragile economic recovery or triggering financial market turmoil due to overly rapid policy tightening. Furthermore, 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 trade remains active. Large amounts of funds continue to be borrowed in low-interest yen and invested in high-yield assets, especially US Treasury bonds and overseas markets.

In this structural environment, even a small interest rate hike by the Bank of Japan is unlikely to reverse the long-term weakness of the yen. On the contrary, each rate hike may provide more room for carry trades, further suppressing the yen's performance. Analysts point out that unless the Bank of Japan shows a stronger hawkish signal or US interest rates enter a clear downward trend, the yen is unlikely to have a substantial chance of reversing its trend.

IV. The US dollar awaits guidance from the non-farm payrolls report.

Amidst a divergence among global central banks, the US dollar is at a critical juncture. This week's November non-farm payroll data is the focus. Experts predict 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 meets expectations, it means the US labor market is indeed cooling, and the Federal Reserve will have ample reason to pause further interest rate cuts, at least until March or April next year for further assessment. The futures market has already begun pricing in this, reflecting a recalibration of future policy pace.

However, more alarming than economic data is the potential erosion of monetary policy independence by political forces. Trump recently publicly called for lower interest rates, stating they should be reduced to 1% or even lower to alleviate the government's debt burden. He also advocated that the next Federal Reserve chairman should consult with him on decision-making, emulating the past "cooperative model." Such remarks have sparked widespread market concerns about the erosion of the Fed's independence. The White House has also been reported to be attempting to increase the proportion of "dovish" members on the Federal Open Market Committee (FOMC), and by the 2026 rotation period, hawks such as Austin Goolsby and Jeff Schmid will lose their voting rights, objectively creating conditions for a policy shift.