EUR/USD Rally Driven by ECB Monetary Tightening Expectations

The EUR/USD is experiencing a rally driven by expectations of the European Central Bank's (ECB) monetary tightening. This has led to a strengthening of the euro against the US dollar, despite the latter's typically favorable backdrop of rising oil prices and increasing Treasury yields.

However, the US dollar remains lackluster, with investors anticipating a sharp fall in Treasury yields following the Treasury's announcement on the volume of Treasury buybacks. Morgan Stanley expects this figure to be $10 billion, which could put pressure on yields across various bonds.

The ECB is expected to raise its deposit rate from 2.25% to 2.5% in September, with markets pricing in a rate rise to 3% by mid-2027. The central bank has compelling arguments for raising the deposit rate, including accelerating GDP growth and rising consumer prices.

However, hiking the deposit rate to 3% may be difficult to justify, as it could exacerbate the eurozone economy's woes and add fuel to the fire of rising European bond yields.