Euro Climbs as Markets Weigh Fed, ECB Outlook

Key Moments

EUR/USD Firmer but Vulnerable as Safe-Haven Demand for USD Looms

EUR/USD advanced after modest losses in the previous session, with the pair trading around 1.1380 during Friday’s Asian session. The rebound, however, faced headwinds as the US Dollar (USD) could draw renewed support from growing geopolitical risks and higher energy prices.

Escalating conflict in the Middle East has the potential to push crude prices higher, raising the prospect of a fresh inflation impulse in the United States. Market participants viewed this as a factor that could prompt the US Federal Reserve (Fed) to resume interest rate increases, limiting the scope for sustained Euro gains against the Dollar.

Fed Expectations Reprice on Inflation and Oil Concerns

Interest-rate expectations, as reflected by the CME FedWatch tool, indicated that money markets were assigning approximately a 35.8% probability of a Fed rate hike this month. The same pricing implied an 82.1% chance of at least a quarter-point hike at the Fed’s September meeting.

These probabilities underscored how an oil-driven inflation shock was feeding into forecasts for a more restrictive Fed stance, supporting the USD and posing a potential drag on EUR/USD in the near term.

Middle East Escalation Heightens Risk Mood

Geopolitical risk intensified following reports that Yemen’s Iran-backed Houthi militants attacked two Saudi oil tankers in the Red Sea, allegedly for breaching a blockade. In reaction, the United States carried out its 13th straight night of strikes on Iran.

Tensions rose further after US President Donald Trump warned of major military punishment for the Houthis and Iran if such attacks persisted, and said he was close to determining a large-scale, unprecedented military operation against Iran.

Such developments contributed to a risk-off backdrop that could bolster safe-haven demand for the US Dollar, even as EUR/USD edged higher in the latest session.

New US Tariff Plans Revive Trade Uncertainty

At the same time, trade policy concerns resurfaced after Bloomberg reported that the United States was preparing to introduce new import tariffs in the 10% to 12.5% range on goods from key trading partners. The move was described as a major initiative to reestablish the Trump administration’s trade barriers after a recent Supreme Court decision.

Under the reported framework, imports from the European Union would face tariffs of at least 10%, with the structure designed to remain consistent with current US-EU trade agreements. This added another layer of uncertainty for the Euro, given the direct implications for EU exports.

ECB Holds Rates After June Hike, Flags Energy-Driven Inflation Risks

In Europe, investors continued to digest the latest decisions from the European Central Bank (ECB). The Governing Council reiterated its objective of returning inflation to its 2% medium-term target, while emphasizing that uncertainty remains elevated and that the full inflationary effect of the energy shock has not yet been fully realized.

Following a 25-basis-point rate increase in June, the ECB opted to keep its benchmark rates unchanged. The deposit facility rate was held at 2.25%, the main refinancing rate at 2.40%, and the marginal lending facility at 2.65%.

Euro Basics and Policy Framework

The Euro and Its Major Currency Pairs

The Euro serves as the currency for 20 European Union member states that are part of the Eurozone. It is described as the second most heavily traded currency globally, behind the US Dollar.

In 2022, it accounted for 31% of all foreign exchange transactions, with an average daily turnover of over $2.2 trillion a day. The most active pair is EUR/USD, which is said to represent about 30% of all FX trades, followed by EUR/JPY at 4%, EUR/GBP at 3%, and EUR/AUD at 2%.

The Role of the ECB in Shaping the Euro

The European Central Bank (ECB), headquartered in Frankfurt, Germany, acts as the reserve bank for the Eurozone. It sets interest rates and administers monetary policy for the bloc.

The ECB’s main mandate is to maintain price stability, which involves either restraining inflation or encouraging growth. Its principal policy lever is the adjustment of interest rates. Comparatively higher interest rates – or expectations of tighter policy – generally tend to support the Euro, while lower rates can weigh on the currency.

Monetary policy decisions are taken by the ECB Governing Council at meetings held eight times per year. The Council is composed of the heads of national central banks from the Eurozone and six permanent members, including ECB President Christine Lagarde.

How Inflation Data Moves the Euro

Eurozone inflation is tracked by the Harmonized Index of Consumer Prices (HICP), which is considered a key data point for the Euro. When inflation runs above expectations, particularly if it exceeds the ECB’s 2% target, policymakers are compelled to raise interest rates to bring it under control.

Higher relative interest rates typically enhance the Euro’s appeal to global investors, as they can earn more on Euro-denominated assets compared with currencies with lower yields.

Economic Indicators and Trade Balance as Euro Drivers

Macro data releases that reflect the strength or weakness of the Eurozone economy can meaningfully influence the Euro. Metrics such as GDP, Manufacturing and Services PMIs, labor market data, and consumer sentiment surveys are commonly monitored by market participants.

A robust growth backdrop tends to be positive for the single currency. It can attract foreign capital and may prompt the ECB to favor tighter policy, which directly supports the Euro. In contrast, soft data usually exerts downward pressure.

Data from the four largest Eurozone economies – Germany, France, Italy, and Spain – carry particular weight, as these countries collectively represent 75% of the bloc’s output.

The trade balance is another important indicator. It measures the difference between the value of exports and imports over a given period. A positive trade balance, in which exports exceed imports, can lift a currency by generating foreign demand for domestic goods and, by extension, the currency needed to purchase them. The opposite holds for a negative trade balance.