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Divergent policy expectations are powering euro gains.

After narrowly avoiding recession earlier in the year, the euro area economy continues to generate above-target inflation, forcing policymakers to maintain a consistently-hawkish stance. The European Central Bank’s series of interest rate hikes is expected to remain uninterrupted for several months to come, with investors currently pricing in two more moves – one later this month, and another in September.

With rate differentials narrowing in its favour and the dollar staging a broad-based retreat, the euro has turned in a respectable performance since bottoming out in late 2022, and gains have accelerated since softer-than-anticipated consumer price numbers drove US yields lower in mid-July. Speculative positioning remains steadfastly bullish and economists are overwhelmingly positive.

But carry returns on the common currency still rival the Japanese yen and Swiss franc near the bottom of the developed-world league tables, and there are reasons to suspect that they aren’t likely to rise in the near future. Consumer inflation expectations fell to a seven-year low in June, and core producer price indices – which have historically led changes in core price measures by roughly 9 months – have fallen sharply, suggesting that markets might consider additional policy rate increases unsustainable.

Price indices, % annual change

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