EUR/USD Slips As Policy Gap Widens On US Inflation And Fed Outlook

EUR/USD slipped to about 1.1365 in early Asian trade on Friday, keeping the pair close to a 13‑month low near 1.1350 as markets leaned further towards additional US rate rises. Attention later turns to the Michigan Consumer Sentiment Index, due for release on Friday, after fresh inflation data strengthened the US Dollar.

In May, the headline Personal Consumption Expenditures (PCE) Price Index rose 4.1% year on year, up from 3.3% in April, moving above 4.0% for the first time in three years as higher energy prices linked to the Middle East conflict fed through. Core PCE increased to 3.4% from 3.3%, the highest annual core reading since October 2023, and CME FedWatch data put the probability of a rate rise at the 15–16 September meeting at nearly 63.4%. The euro also faced pressure from European Central Bank (ECB) policy signals: the ECB lifted its deposit rate by 25 basis points to 2.25% in June, while policymakers indicated a measured approach to conflict-related spillovers and longer-term inflation dynamics in the Eurozone.

Persistent Policy Divergence Favors Further Euro Weakness

Given the widening policy gap between a hawkish Federal Reserve and a dovish European Central Bank, we see continued weakness in the EUR/USD pair. The dollar is gaining strength as May’s Personal Consumption Expenditures (PCE) inflation in the U.S. jumped to 4.1%, pushing markets to price in a rate hike. We should position for the Euro to test and potentially break below its 13-month low in the coming weeks.

This policy divergence is now a clear statistical reality. While the U.S. core PCE hit a multi-year high of 3.4%, recent Eurostat flash estimates show the Harmonised Index of Consumer Prices (HICP) in the Eurozone is lagging significantly at just 2.9%. This substantial inflation differential gives the Fed a clear mandate to tighten policy while the ECB remains cautious.

Trading Strategy: Options, Futures, And The Carry Trade

We are therefore looking at buying EUR/USD put options with expiration dates in August and September. Strike prices below the 1.1300 level, such as 1.1250 and 1.1200, appear attractive for capturing the next leg down. This strategy allows us to profit from a falling Euro while clearly defining our maximum risk.

Historically, periods of significant Fed and ECB policy divergence have led to prolonged currency trends. We saw a similar dynamic in 2014-2015 when the Fed signaled an end to quantitative easing while the ECB was just beginning its own, causing EUR/USD to fall over 20% in under a year. The current setup, driven by inflation and geopolitical energy shocks, is showing a similar pattern.

For traders comfortable with leverage, we are establishing short positions in EUR/USD futures contracts. The immediate target is the 1.1300 psychological level, with a secondary target near 1.1240. We will use a tight stop-loss above the recent consolidation area to manage risk effectively.

The market’s conviction is high, with the CME FedWatch Tool now indicating a 63.4% probability of a Fed rate hike at the September 15-16 meeting. This is a strong signal that is not yet fully reflected in the currency’s price, providing an opportunity for further downside. We view this as a high-probability catalyst for continued dollar strength.

On the other side, ECB President Lagarde’s comments suggest a reluctance to respond aggressively to the energy price shock from the Middle East conflict. With the ECB’s deposit rate at only 2.25%, the widening interest rate differential in favor of the dollar will continue to weigh heavily on the Euro. This makes holding short Euro positions an attractive carry trade.