EUR/USD tests two-month highs as rate expectations shift

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EUR/USD tests two-month highs as rate expectations shift

ECB expectations turn more hawkish

In the eurozone, final July inflation accelerated to 2.9% year over year from 2.8%, with services making the largest contribution to price growth, while the energy component once again became a significant inflationary factor. At the same time, the currency bloc’s economy expanded by 0.4% quarter over quarter in Q2, a clear improvement from the stagnation seen at the start of the year. Against this backdrop, the market has largely abandoned expectations of a return to ECB easing. After the deposit rate was left unchanged at 2.25% on July 23, swaps are pricing in roughly an 83% probability of a 25-basis-point hike as soon as September 10, while a Reuters poll shows that 57 of 69 economists also expect the rate to rise to 2.50%.

Within the eurozone, the picture is becoming more mixed, but this has not yet prevented the euro from strengthening. Germany’s GDP grew by only 0.2% quarter over quarter in Q2, while investment remained weak. However, July inflation accelerated to 2.8%, mainly due to energy, while core inflation eased only to 2.4%. Meanwhile, the ZEW economic sentiment index jumped to 34.2 points in August, accompanied by a noticeable improvement in the assessment of current conditions, reinforcing hopes for a gradual recovery in the region’s largest economy.

France also emerged from contraction, with GDP expanding by 0.2% after a 0.1% decline in Q1. Consumer spending began to recover, July inflation stood at around 2.1% year over year, and Banque de France estimates that the economy could grow by another 0.2% in Q3. As a result, the eurozone macro backdrop remains weak in absolute terms, but the combination of positive growth and inflation running almost a full percentage point above target is forcing investors to view the ECB as significantly more hawkish than just a few months ago.

U.S. data weaken support for the dollar

In the U.S., by contrast, the environment is becoming less supportive for the dollar. July CPI slowed to 3.4% year over year from 3.5%, core inflation eased to 2.5%, and monthly price growth was only 0.1%. Even more important is the condition of the labor market. Nonfarm payrolls fell by 23,000 in July, while the previous two months were revised down by a combined 103,000, although the unemployment rate remained near 4.1%.

U.S. GDP growth also slowed to an annualized 1.5% in Q2 from 2.1% in Q1. The Fed kept its target range unchanged at 3.50%-3.75% in July, but following the softer data, the probability of a September rate hike has fallen sharply. Current market pricing assigns around a 67% probability to rates being left unchanged. Today, the key event will be the release of the minutes from the Fed’s July meeting, which should show how broad support for further policy tightening is within the FOMC after three members voted for a rate increase.

Middle East risks cap bullish momentum

The main risk to the bullish EUR/USD scenario remains the situation in the Middle East. The temporary arrangements between the U.S. and Iran expired without a final agreement, negotiations are effectively frozen, and Tehran and Washington are giving conflicting assessments of the status of the Strait of Hormuz. Brent crude has returned above $91 per barrel, well above pre-conflict levels, while the risk of renewed attacks on shipping and further restrictions on flows through the strait remains.

For the euro, this is a two-sided factor. Higher energy prices increase the likelihood of an ECB move in September and support eurozone yields, but at the same time they worsen Europe’s terms of trade and, in the event of a serious escalation, could revive demand for the dollar as a safe-haven asset.

Nevertheless, EUR/USD’s return to resistance increases the chances of a breakout and a move toward 1.1660-1.1680, although selling into strength should not yet be ruled out. Pullbacks toward 1.1580, as I noted in EUR/USD pulls back from two-month high as Fed rate hike bets fade, could be used for buying, while a break below this support would open the way toward 1.1540-1.1520 and significantly reduce the likelihood of further upside in the pair.

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