The hawkish surprise from the Federal Reserve has led to tighter financial conditions and a deterioration in global appetite for risk. As a result, EUR/USD quotes have collapsed to annual lows. According to Credit Agricole, this aligns with the dollar smile theory. Due to weakening risk demand and higher U.S. rates, capital is flowing there. This leads to a rally in the American currency.
There is always a choice between the economy and inflation. Central banks prefer to keep prices under control. If it were otherwise, the European Central Bank would not have raised the deposit rate in June; it would have expressed concerns about GDP slowing down due to rising energy prices amid the Middle Eastern conflict. The decline in Brent after the conclusion of the U.S.-Iran standoff is a boon for the Eurozone economy. However, the chances of the ECB continuing its monetary tightening cycle are also diminishing. This becomes a catalyst for the decline in EUR/USD.
Price Dynamics of Oil
Oxford Economics has stated that it no longer expects a rise in the deposit rate, as the Washington-Tehran deal, followed by a fall in oil prices, will make the period of high prices very short. This will result in a hawkish pause from the ECB. Capital Economics follows a "one and done" approach, meaning the end of the tightening cycle after it starts in June. Nomura and RBC Capital Markets have reduced the number of rate hikes they anticipate from the ECB.
All of this contrasts with the Federal Reserve's position. The futures market anticipates a federal funds rate increase and indicates a high probability of a second act of monetary tightening in 2026. This leads to an expansion in the yield spreads between American and German bonds, creating a tailwind for the continued decline in EUR/USD.
Falling oil prices also have a positive effect on the U.S. economy and theoretically slow inflation. However, the United States has a growth driver that other countries lack. This refers to the construction of data centers for artificial intelligence technologies. These centers are receiving colossal investments, and component prices are not a concern. As a result, the cost of various goods is rising, fueling the CPI.
In the future, AI will increase productivity, accelerating economic growth without a corresponding spike in inflation. However, as history shows, at the initial stage of utilizing new technologies, prices tend to accelerate.
Thus, markets anticipate a slowdown in European inflation due to falling oil prices. Will consumer prices in the U.S. decline from May peaks? It remains unknown. This creates the groundwork for divergence in monetary policy and weakens the euro.
From a technical standpoint, the daily chart of EUR/USD shows the formation of an inside bar. A breakout below its low at 1.1335 will allow for increasing the shorts that were established from 1.1415. Conversely, a successful test of the high at 1.1375 would be a reason to move to long positions.
