EUR/USD Gains Limited by High Oil Prices and ECB Rate Hikes

The EUR/USD currency pair has been making gains, but these advances are exposing the limitations of the policy convergence trade. The euro has traded at $1.15745 against the dollar on Tuesday, down 0.06% on the session, after pulling back below the 1.1600 handle during Asian hours. This marks the third consecutive session in which the pair has approached this figure and failed to close above it.

The eurozone's inflation is driven by Brent crude oil prices, which have surged to $91.76 per barrel, a level not seen since 2007. This combination revives the inflation premium and the dollar's carry simultaneously. The euro's problem is that it is being asked to rally on a policy convergence story while this commodity drives eurozone inflation.

The European Central Bank (ECB) has been pricing in two more interest rate hikes, with the first potentially at the September 10 meeting. The market is also pricing in a rate differential compression of 50 basis points, which historically supports a 300 to 500 pip move in EUR/USD.