Euro: How Much Further Can It Rise?

1. Driving factors behind the current euro rally

First, the widening difference in economic expectations between Europe and the US continues, providing fundamental support for the euro. Economic data in the eurozone for August rebounded across the board: Manufacturing PMI preliminary value rose to 52.8, the highest since May 2022; Services PMI held at 51.7; Composite PMI recorded 52.1, reaching a nine-month high. In contrast, core US data such as non-farm payrolls and retail sales continue to weaken, and the gap in the Citigroup Economic Surprise Index between Europe and the US is increasing.

Second, the Euro-US yield differential favors the euro, with the 2-year German-US spread rising by 30bp since July, driving EURUSD upward. The rate market currently prices the probability of an ECB rate hike in September at 95%, meaning a hike is almost certain. The probability of a Fed rate hike in September is only 35%, and with US economic data continuing to weaken, it's highly likely the Fed will pause rate hikes in September. Due to the November midterm elections, if the Fed does not raise rates in September, it is very unlikely to start a hike cycle in October. Historically, the Fed has never started a rate hike cycle at the meeting preceding the Congressional elections.

Third, concerns over US dollar credit are rising, and dollar bulls are continuously retreating. The catalyst for this euro rally above the 200-day moving average was the US Treasury's announcement to double long-term debt buybacks. This move raised market concerns about US debt risks and the dollar’s credit system, triggering crowded euro short positions to unwind.

2. Can the rally continue?

The above euro-positive factors are expected to continue supporting the euro’s rise in the medium to long term. From options market pricing, EURUSD RR has increased, with 3M 25D RR reaching its highest level since March this year, signaling the market remains bullish on the euro.

However, in the short term, the risk of a euro pullback is rising, as several upper resistance factors include:

On one hand, energy prices remain elevated, which is negative for eurozone trade conditions. Brent crude prices are still above $90, and European natural gas prices remain high. The risk of the Iran situation escalating further before the midterm elections cannot be ruled out in the medium term.

On the other hand, German political uncertainty limits upside potential. In September, Germany will hold autumn state elections. If the Alternative for Germany (AfD) performs better than expected, it will raise European political risk and negatively impact the euro.

3. Summary

1. Although the medium-term bullish logic for the euro remains unchanged (European economic outperformance, ECB rate hike, and concerns over US debt affecting dollar credibility), in the short term, these positives may have been largely priced in, and the euro lacks further drivers to break above 1.18 in a unilateral move.

2. Continuously high energy prices will be a cap for the euro’s upside. Technically, EURUSD may need to retest the area around 1.16-1.1630 first. It is advised to wait for a pullback before taking long positions.

3. The main event to focus on this week is the Jackson Hole meeting, with the theme of “Financial Innovation: Impacts on Payments and Policy.” Fed Chair Walsh (speaking at 10 PM Beijing time, August 28) is unlikely to signal anything for the September meeting, so market volatility may be limited. It is expected that markets may continue with a low-volatility pattern this week.