Fed's dovish signals may lift euro 3% as rate decision looms

The Federal Reserve's July 28-29 meeting has become a coin toss, with traders pricing a 36% chance of a quarter-point hike as inflation concerns collide with a softening economic outlook, Commerzbank analysts said. The widely watched CME Group FedWatch Tool shows a 64% probability that the Federal Open Market Committee holds its benchmark rate at 3.5% to 3.75%, a marked shift from the near-90% probability of a hold just weeks ago as oil prices surged and tariff threats resurfaced.

"If the Fed signals a willingness to cut rates later this year or adopts a more dovish tone on inflation, the dollar could weaken significantly, providing a tailwind for the euro," a Commerzbank strategist said in a note published Tuesday. The euro traded at $1.0875 early Tuesday, while the DXY dollar index held near $101.52, just below resistance at $101.65. The dollar index has climbed 4% this year, supported by the Fed's hawkish posture and the relative resilience of the U.S. economy.

By September, traders price a 79% cumulative probability of at least one quarter-point hike, and by December the FedWatch Tool leans toward a half-point increase with a 37.7% probability of a 4% to 4.25% target rate. The repricing reflects renewed inflation pressures from the Iran war's impact on oil prices and fresh tariff threats from the Trump administration, which on July 24 released new duties of 10% to 12.5% against 60 countries for alleged forced labor practices.

A dovish pivot would mark a sharp reversal from Chairman Kevin Warsh's "resolute commitment" to price stability, delivered to Congress on July 14-15. Warsh repeatedly told lawmakers the Fed would work on its "resolute commitment" to restore price stability, but he eliminated forward guidance language from the Fed's post-meeting statement in June, leaving markets to guess at the policy path. The last time the Fed used similarly ambiguous language was in early 2025, which preceded a 50-basis-point rate cut over the following three months as the labor market softened. Nonfarm payrolls have averaged roughly 150,000 per month over the past three months, near the breakeven rate estimated by the Atlanta Fed.

Rate Differentials and the Euro's Path

The euro's upside depends on more than just the Fed. The European Central Bank held its deposit rate at 2.25% last week, with President Christine Lagarde saying policymakers were not guiding markets toward a certain path. Eurozone GDP and inflation data due this week will shape expectations for the ECB's September meeting, where traders see a roughly 50% probability of a quarter-point cut. The rate differential between the Fed's 3.5% to 3.75% target and the ECB's 2.25% deposit rate currently stands at 125 to 150 basis points in favor of the dollar, a gap that would narrow if the Fed cuts or signals a dovish tilt.

Goldman Sachs Chief U.S. Economist David Mericle said in a note that modest rate hikes would have limited impact on curbing price pressures from supply shocks. "There is little reason to think that the limited hikes currently being entertained by the bond market would provide much help in bringing inflation down," Mericle said. The note attributed most of the overshoot of the Fed's 2% target for core PCE to tariffs, the Iran war, and mismeasurement of artificial intelligence. June headline CPI dropped to 3.4% from May's 4.2%, but core inflation remained elevated, and the Fed's preferred PCE measure stood at 4.1% in May, more than double the target.

For the euro to gain 3% against the dollar, the Fed would need to signal a clear dovish tilt — either by holding rates steady with language that opens the door to cuts, or by acknowledging that supply-driven inflation is beyond the reach of monetary policy. The FOMC's next meeting after July is Sept. 15-16, following the Jackson Hole Economic Policy Symposium in August where Warsh is expected to deliver his inaugural keynote address. Markets will scrutinize his speech for any shift in tone that could validate the euro's upside case.

This article is for informational purposes only and does not constitute investment advice.