EURUSD stares at the bond market like a rabbit hypnotized by a boa. European bond yields are rising at a faster pace than their US counterparts. The market draws a seemingly obvious conclusion: the ECB is far more hawkish than the Fed, which means it’s time to buy the euro. Christine Lagarde is expected not only to raise rates but also to send a clear signal that the monetary tightening cycle will continue. Meanwhile, the odds of the Fed delivering two rate hikes are steadily declining.
The problem is that this yield rally is nothing more than a pretty facade. What lies beneath hardly bodes well for EURUSD. Rising rates inevitably trigger a sell-off in debt securities. Investors are quickest to dump French and Italian bonds, which are burdened by severe budgetary issues. Germany has also taken a hit: the yield on 30-year Bunds has surged to its highest levels since 2011.
The political backdrop in Germany only exacerbates the situation. Friedrich Merz has not only lost the regional elections but has also become a scapegoat within his own party. His CDU colleagues are blaming his miscalculations for the chancellor’s approval rating plummeting to just 15%. A vote of no confidence and snap parliamentary elections cannot be ruled out, although Morgan Stanley dismisses this as an unlikely tail risk. A far more realistic base case scenario appears to be the formation of an AfD-backed minority government.
Escalating political risks, surging oil and gas prices, and the resulting threat of accelerating inflation are forcing the ECB to tighten its policy. This triggers sell-offs in the European bond market, driving yields higher. The paradox is that investors mistakenly interpret this forced yield spike as an increase in asset attractiveness, continuing to buy euros and prop up EURUSD.
Across the Atlantic, the picture is entirely different. Following the release of the US jobs report, the probability of the Fed hiking rates twice in 2026 has dropped from 50% to 42%. The odds of a September rate hike are hovering around 60%.
Thus, EURUSD bulls, captivated by the surface-level yield rally, have completely lost sight of its fundamental drivers. In Europe, the drivers are political turbulence and fears of a repeat energy crisis. In the US, however, rising rates are underpinned by confidence in economic resilience. The US financial system is more than capable of digesting 5% bond yields: by historical standards, this isn’t exceptionally high, and the current rise in yields is merely a return to normal after decades of financial repression.
The Forex market is making a mistake by piling into EURUSD longs ahead of the US inflation report. The irony is that this very data could serve as a cold shower, forcing traders to come face-to-face with their own delusion.
