EUR/USD breaks above 1.1580 as Fed rate hike expectations fade

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EUR/USD breaks above 1.1580 as Fed rate hike expectations fade

U.S. data weakens case for further Fed tightening

The July employment report showed a decline of 23,000 in nonfarm payrolls, while the data for May and June were revised down by a combined 103,000. Subsequent statistics were also unfavorable for the dollar: retail sales fell by 0.6% m/m in July, CPI rose by only 0.1% m/m, while annual inflation slowed to 3.4% from 3.5%, with the core reading at 2.5%.

PPI did not change at all over the month. As a result, the market now estimates the probability of a Fed rate hike in September at around 31%, compared with more than 50% immediately before the CPI release, while only about 21 bps of tightening remains priced in by the end of the year. At the same time, after the July 29 meeting, the Fed rate remains at 3.50-3.75%, although three FOMC members voted for a 25 bp increase at that meeting.

ECB outlook and eurozone inflation support euro

For the euro, the situation looks somewhat more favorable. The eurozone economy grew by 0.4% q/q and 1.0% y/y in Q2, while inflation, according to Eurostat’s preliminary estimate, accelerated to 2.9% y/y in July from 2.8%, with energy prices rising by 10%. These figures leave the ECB less room for accommodative policy. At its July 23 meeting, the regulator kept the deposit rate unchanged at 2.25% but emphasized the risks of second-round inflationary effects from the energy shock.

According to the latest Reuters poll, 57 out of 69 economists expect the deposit rate to be raised by 25 bps to 2.50% as early as September. Germany, meanwhile, remains the weak link: GDP grew by only 0.2% q/q in Q2, investment declined, and domestic demand remains subdued. At the same time, inflation in the country accelerated to 2.8% in July, mainly due to energy.

An additional risk comes from severe drought and low water levels on the Rhine, which could once again increase transportation and production costs for German industry. Thus, the market is now seeing an increasingly pronounced divergence: the probability of another ECB rate hike is rising, while expectations of a similar move by the Fed are declining, which fundamentally supports EUR/USD.

Middle East tensions remain key downside risk for EUR/USD

The main factor capable of limiting the euro’s advance remains the Middle East. Negotiations between the U.S. and Iran have stalled, while shipping through the Strait of Hormuz has declined noticeably following attacks on tankers. Brent traded at around $89 per barrel today, after gaining more than 5% over the previous week.

So far, there has been no significant physical reduction in oil supply, and the market views the situation mainly as a geopolitical premium. However, a new escalation or damage to oil infrastructure could quickly push Brent back above current levels. For EUR/USD, this represents a double negative risk: a sharp rise in oil prices would worsen the terms of trade for the energy-importing eurozone while simultaneously strengthening demand for the dollar as a safe-haven asset. In addition, more expensive energy could once again raise inflation expectations in the U.S. and bring Fed tightening bets back into the market.

Thus, despite the break above resistance around 1.1580, the current EUR/USD advance can still be used for moderate selling, against which a decline toward 1.1560-1.1540 remains possible. However, as I noted in EUR/USD holds near 1.1550 as Fed expectations soften, the ability to hold above 1.1580-1.1560 would indicate potential for further growth toward 1.1660-1.1700.

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