The EURUSD fell to lows not seen since early 2025, and threatening to erase all the gains seen last year after US President Donald Trump took office. The drop comes despite hotter than anticipated in partial Flash CPI results, with German headline inflation accelerating more than economists had expected.
So, if inflation in the Eurozone is rising, why isn’t the Euro also getting stronger in anticipation of more rate hikes? There are two factors at play, on either side of the Atlantic. The dollar has strengthened even after US PCE inflation was softer than anticipated, due to higher bond yields. On the European side, ECB President Christine Lagarde announced a substantial pivot during her address to the European Parliament. However, markets are not entirely convinced about the change in strategy, leaving room for a potential rebound in the Euro.
The ECB’s Major Policy Change
The consensus among the market, economists and even the ECB itself appeared to be that higher energy costs would push inflation higher, and rates would have to rise to tame it. That put the ECB as the most hawkish on the board, with the market pricing in at least one rate hike by the end of the year, with high odds of tightening in October.
Then Lagarde signalled a more cautious approach before the European Parliament, suggesting that there were no “second round” effects from higher energy prices. This was a change of tone from most European central bankers who had expressed concern that higher crude prices would filter through the economy. This is important, because generally the central bank doesn’t care about temporary ups and downs with inflation, but is looking to keep long-term inflation as close to target as possible. If the ECB doesn’t see “second round” effects, then there is much less reason to raise rates.
The Bond Market Doing The Central Bank’s Work
Lagarde also took note of rising yields across Europe. While there has been a lot of attention put on UK and US yields rising to multi-decade highs, long-term yields in the Eurozone have risen as well. The difference is that the Anglosphere central banks have much higher base rates, so the relative rise in Eurozone yields hasn’t been as noticeable.
But, higher yields have the same effect as raising rates. They constrain financial conditions and slow growth in a very similar way to what raising central banks do. In fact, the ECB hikes rates with the intention to push up bond yields. So, if the market is raising yields on its own, the ECB has less need to raise rates.
The Odds and the Data
Markets have dropped their expectations of a rate hike at the ECB’s meeting later this month to just 44% from over 70% around a week ago. The market also largely ignored the hotter than expected German CPI data, because it’s headline inflation (that is, includes energy costs). What the market is waiting for is the core rate, which excludes energy and food costs, to show whether there are second-round effects.
The consensus is that Friday’s Eurozone flash September headline CPI will jump to 3.6% from 3.2% in the previous month. Meanwhile, the core rate is projected to rise to 2.6% from 2.4%. If the core rate rises, it means that the ECB could still “cautiously” raise rates. But if the core rate misses, or even declines, the market could price out a rate hike in October, leading to further downside for EURUSD.
