A decline in geopolitical risks and oil's return to pre?war levels did not create an environment in which the US dollar weakened. Investors quickly refocused on monetary policy, and a hawkish shift at the Federal Reserve sent EUR/USD tumbling to one?year lows. The euro found a bottom thanks to a string of disappointing US economic reports and FOMC officials' remarks, but its late-week rally looks more like profit-taking on short positions than a reversal of the downtrend.
Nordea notes that since the June Fed meeting, US 2-year Treasury yields have risen while their German counterparts have fallen. That widened the bond yield differential to 160 bps, the largest gap in a year. The bank expects the Federal Reserve to tighten policy twice in 2026 and once more in 2027. With the ECB reluctant to make any adjustments, this will push EUR/USD even lower.
EUR/USD dynamics and the US-Germany bond yield spread
Bank of America holds a similar view and forecasts the euro will fall to $1.12 by Q3 amid three acts of Fed tightening — which the bank believes will occur this year.
What could help the euro? ECB Chief Economist Philip Lane has expressed concern about entrenched inflation, and Governing Council colleague Isabel Schnabel said the tightening cycle should continue. However, markets put more weight on Christine Lagarde. According to Lagarde, the ECB does not need an aggressive response to the Middle East conflict: oil prices are falling, and consumer prices in the eurozone may follow.
Indeed, inflation expectations in the currency bloc have eased, prompting the futures market to doubt even a single ECB deposit rate hike. Monetary policy divergence is becoming the guiding star for EUR/USD bears.
The slide in the major currency pair was aided by an element of surprise. Investors anticipated Kevin Warsh to emphasize rate cuts at his first meeting as Fed chair, but instead he delivered hawkish rhetoric. By contrast, Christine Lagarde signaled that futures market rate expectations were too high, even though earlier Governing Council members had been united in talking about further tightening. The ECB chief's dovish pivot was a blow to the regional currency.
Technically, on the daily chart, EUR/USD bounced off a convergence zone formed by two pivot levels at 1.1335–1.1350. It makes sense to add more long positions from 1.1375 if the instrument holds above 1.1400. If bulls fail to do that, traders should resume selling.
