Commerzbank’s Michael Pfister argues that recent EUR/USD weakness reflects Dollar strength rather than Euro fragility, with Fed expectations driving the move. He notes falling Oil prices and collapsing inflation expectations limit ECB hike prospects, while a softer Dollar would require Fed expectations to retreat. Commerzbank expects Euro area inflation to stay relatively high, but sees 1.18 in EUR/USD only returning over a longer horizon.

Euro strength constrained by Fed outlook

"It is important to bear in mind that lower EUR/USD levels are not due to any weakness in the euro itself. Since the decline began in mid-May, the euro has actually appreciated slightly against the G10 average. This movement is therefore entirely driven by a stronger US dollar, which has now even surpassed the peak reached during the height of the Iran conflict."

"Given that oil prices are falling again, however, the euro area inflation rate is likely to have peaked in May. It is therefore hardly surprising that inflation expectations have collapsed in recent weeks. A slightly lower inflation rate for June is likely to be reported this week."

"However, Fed expectations would need to return to previous levels. The collapse in inflation expectations would provide a reason for this, too. But despite expectations finally having fallen, the market seems to assume that the new Fed Chair, Kevin Warsh, is a hawk who intends to tighten monetary policy."

"Our economists do expect inflation in the euro area to stabilise at a fairly high level in the coming months. The expected decline in June would therefore not mark the start of a new downward trend. If inflation reports in the coming months suggest more persistent price pressures, the euro is likely to benefit."

"In the longer term, however, higher EUR/USD levels are more likely to be driven by a weaker US dollar, although this is also likely to take some time. There is currently simply no decisive event to price out the Fed’s interest rate hikes. This week, the Supreme Court is expected to deliver its ruling on the case concerning Lisa Cook, the Fed governor whom the US President wishes to dismiss."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)