EUR/USD pulls back from two-month high as Fed rate hike bets fade

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EUR/USD pulls back from two-month high as Fed rate hike bets fade

Weak U.S. data reshape Fed expectations

The main shift in the currency balance has come not so much from renewed optimism over the European economy as from a noticeable reduction in expectations for further Fed tightening. A weak U.S. July labor market report showed nonfarm payrolls falling by 23,000, while retail sales declined 0.6% m/m in July. At the same time, CPI rose by just 0.1% m/m, with annual inflation at 3.4%, while PPI was unchanged on the month. Following these releases, the probability of a Fed rate hike in September fell to around 30–35%, sharply contrasting with more hawkish expectations for the ECB.

European data, meanwhile, look more resilient than a few months ago, although they are also reinforcing inflation risks. Eurozone GDP expanded by 0.4% q/q in the second quarter after stagnating at the start of the year, while employment increased by 0.1%. Germany posted GDP growth of 0.2% q/q and 0.9% y/y, although July inflation accelerated to 2.8% from 2.3% in June, largely due to energy prices. In France, the economy also grew by 0.2% q/q after contracting by 0.1%, while CPI accelerated to 2.1% y/y and harmonized inflation rose to 2.4%.

ECB outlook keeps euro supported

This combination of moderate growth and renewed price pressures makes further ECB easing increasingly unlikely. Following its July pause, the deposit rate remains at 2.25%, while markets are now pricing in more than an 80% probability of a 25-basis-point hike at the September 10 meeting. This shift in expectations has significantly improved the euro’s relative appeal and remains one of the key fundamental arguments against EUR/USD returning to its June lows.

Middle East risks cap upside potential

The main factor capable of quickly changing this balance remains the situation in the Middle East. Following the end of the temporary ceasefire between the U.S. and Iran, prospects for a lasting diplomatic settlement have deteriorated again, while restricted shipping through the Strait of Hormuz continues to support the oil risk premium. Brent crude rose 2.65% on August 17 to $90.87 per barrel.

This is particularly sensitive for the euro: higher oil and gas prices worsen the eurozone’s terms of trade and simultaneously add to inflationary pressures, while the dollar benefits from additional safe-haven demand. As a result, resistance around 1.1600–1.1620 may continue to cap bullish momentum, increasing the risk of a break below 1.1560 and a decline toward 1.1540–1.1520.

Nevertheless, should such a pullback occur, EUR/USD, as I warned in EUR/USD breaks above 1.1580 as Fed rate hike expectations fade, could attract renewed buying interest around these levels.

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