EURUSD reapproaches key resistance near 1.16 despite speculated options market correction and higher U.S. interest rates. However, the European Central Bank (ECB) has indicated that a strong euro is not a concern, and new geopolitical fundamentals may point to a continuation of the bullish sentiment toward the world’s second most traded currency.
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ECB vs. the Risk Balance
The escalation of conflict in the Middle East is forcing the European Central Bank (ECB) to revisit its economic outlook. Since the beginning of the year, Eurozone policymakers have been more worried about deflation than inflation, which in some economies has dropped below target primarily due to falling energy prices. Current upward pressure on oil prices and uncertainty around supply chains could support higher global energy prices while also posing a risk to European industrial output.
In light of these emerging risks, ECB members are calling for greater flexibility. Bundesbank President Joachim Nagel emphasized today that, with such rapidly changing conditions, it is unwise to get used to the "mission accomplished" on inflation. Meanwhile, according to Luis de Guindos, the inflation risk balance in the Eurozone remains broadly even, although in the medium term, tariff-related issues could weigh on both economic growth and inflation. De Guindos also stated that an exchange rate around 1.15 is not problematic for monetary policy and that he does not expect the euro to appreciate sharply in the near term.
New Fundamentals on the Horizon
The yield spread between German and U.S. 10-year bonds remains steady despite the recent rise in EUR/USD. While monetary factors might suggest that the euro is overvalued, a closer look at other fundamentals offers the world’s second-largest currency some room for further appreciation. Recent geopolitical turbulence has increased capital flows into safe-haven currencies, with the euro benefiting from controlled inflation, prospects of economic recovery, and institutional stability.
Moreover, the market may overreact to any dovish signals from Jerome Powell following Wednesday’s interest rate decision. Even though no rate cut is expected at the upcoming meeting, the Federal Reserve is under pressure to lay its cards on the table and address lower-than-expected inflation and the mixed signals from the labor market. A relatively dovish dot plot could therefore push the yield spread back toward current highs in EUR/USD.
Source: XTB Research
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