Euro Surges Amid Fed Rate Cut Expectations, Diverging ECB Policies

Euro Nears Four-Year High on US Rate Cut Hopes

The euro is heading towards its highest level in four years as traders brace for a potential Federal Reserve rate cut this week. This expectation is solidifying the growing divergence between the monetary policies of the Fed and the European Central Bank (ECB).

The euro-dollar exchange rate climbed to its highest point since July 3 on Tuesday, approaching the 1.18 mark. The pair is up nearly 14% in 2025 so far, and is on track for its best nine-month performance on record.

If the euro surpasses its July high of $1.1829, it would mark its strongest level since September 2021. Options markets suggest this could pave the way for a run towards the closely watched 1.20 level.

Demand for the euro is being buoyed by market expectations that the ECB will not undertake further rate cuts, while the Fed is seen as on the cusp of beginning an easing cycle. The prospect of three 25-basis-point rate cuts by the Fed before year-end is enhancing the appeal of the single European currency.

One-week risk reversals, a gauge of positioning and market sentiment, are showing a steady increase in demand for euro call options since the ECB signaled it has completed its easing cycle.

Data from the Depository Trust & Clearing Corporation (DTCC) also confirms this: of the euro-dollar options traded on Monday, more than two-thirds were bullish bets, with significant interest in options with a strike price above 1.20.

According to foreign exchange traders familiar with fund flows, who requested anonymity because they are not authorized to speak publicly, hedge funds previously seeking bullish exposure through complex structures are now shifting to simple bets on upside, a sign of growing market confidence.

EUR/USD Call Option Bets Targeting 1.20 Heat Up

The latest US Commodity Futures Trading Commission (CFTC) data shows that net euro long positions have risen to their highest level since early July, signaling bullish sentiment.

However, Reuters market analysts believe this optimism may be short-lived. If the Fed’s stance is less dovish than anticipated, US Treasury yields could rise, diminishing the euro's appeal as investors re-adjust their expectations for rate cuts. This could lead to a widening of interest rate differentials, boosting the dollar's yield advantage and exerting downward pressure on the EUR/USD.

Furthermore, if Powell's press conference lacks dovish hints, euro long positions could be unwound, adding to selling pressure. Conversely, if the Fed's stance is more dovish than expected, US Treasury yields and the dollar could fall sharply, potentially allowing the EUR/USD to re-enter a broader uptrend and target levels above 1.20.

Strategists at Morgan Stanley stated that tactical dollar positioning is neutral ahead of the Fed decision. This could mean that the euro still has room to run if policymakers confirm market bets for three rate cuts this year.

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