The euro traded lower against the US dollar during the Asian session on Wednesday, touching a near five-day low of 1.1395 before rebounding. The pair is currently hovering around the 1.1410 level. Concerns over persistent inflation are pushing traders to price in a more hawkish policy path from the European Central Bank, providing short-term upward momentum for the euro.
ECB Policy Outlook: September Hike Fully Priced, December Deposit Rate Could Rise Further
The ECB raised its key interest rate to 2.25% at its June policy meeting. The consensus expectation is for the central bank to leave the deposit rate unchanged at 2.25% at its July meeting on Thursday, maintaining a cautious, data-dependent stance.
However, money market pricing is already showing clear hawkish signals. The deposit rate is expected to rise further by December, with additional increases projected for February 2027, significantly above current levels. More notably, a September rate hike is now fully priced in by the market, reflecting growing investor concern about the eurozone's inflation outlook.
This shift in pricing stems primarily from the ongoing Middle East conflict, which continues to push energy prices higher. Rising costs for crude oil and natural gas could feed into core inflation through supply chains, increasing price stability pressures. Sticky services inflation and strong wage growth in the eurozone also support market expectations that the ECB will need to maintain a restrictive policy stance for a longer period.
Geopolitical Tensions: US-Iran Conflict Escalates, Safe-Haven Demand Caps Euro Gains
However, the euro's further upside potential may be limited by geopolitical factors, as military conflict between the US and Iran continues to escalate.
Reports indicate that US forces conducted strikes against Iranian targets for an 11th consecutive day on Tuesday. Iran has warned the US against attacking its nuclear facilities.
Iran's top joint military command stated that if the US attacks Iranian nuclear sites, Tehran will expand the scope of its retaliation to target US forces and allied interests in the region.
The ongoing escalation of the US-Iran conflict is providing safe-haven support for the US dollar, creating a headwind for the euro. Marginal changes in geopolitical risk will be a key variable for the euro's short-term direction.
Institutional Perspectives
JPMorgan believes that while the US dollar shows short-term resilience, expectations for a Federal Reserve policy pivot towards easing will gradually weaken the greenback. Meanwhile, recovering European economic growth and the ECB's tightening path will support the euro. The bank expects the euro to gradually appreciate from its current 1.08-1.10 range against the dollar, with a full-year target around 1.15-1.18. Key drivers include the view that while eurozone inflation faces energy shocks, services and wage growth provide underlying support, and the ECB may maintain higher interest rates for longer into 2026.
The bank notes that the US fiscal deficit and political uncertainty are long-term drags on the dollar, which should benefit the euro's relative performance.
In its July monthly FX outlook, MUFG argues that the US dollar faces depreciation pressure in 2026, while eurozone policy normalization and economic resilience provide support. With the euro currently around 1.09 against the dollar, MUFG expects it to rise to 1.12 by the end of the third quarter and move higher in the fourth quarter.
MUFG emphasizes that the ECB maintaining a hawkish stance against a backdrop of rebounding energy prices will narrow its interest rate differential with the Fed. An improvement in global risk appetite would also benefit the euro.
The bank is positive on the euro's safe-haven attributes as an alternative to the dollar but warns that trade policy uncertainty could trigger short-term volatility.
Summary
The euro strengthened against the dollar on Wednesday, supported by a hawkish ECB outlook. Concerns over persistent inflation have led money markets to fully price in a September rate hike and anticipate a further rise in the deposit rate by December. However, the euro's potential for further gains may be capped. The escalating US-Iran military conflict, with US strikes for an 11th consecutive day and Iran's warning of expanded retaliation, is fueling safe-haven demand that supports the US dollar.
Thursday's ECB policy meeting will be a key catalyst for the euro's short-term direction. While rates are expected to remain unchanged, signals regarding a September hike will be the primary focus for markets.
In the near term, the euro may trade within a range of 1.1350 to 1.1500, with the direction of any breakout dependent on ECB policy signals and geopolitical developments.
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