The euro delivered a standout performance last week, breaking past the key 1.16 resistance level and surging above 1.17 before retreating slightly on Friday evening. As the new trading week commenced, the currency continued its pullback on Monday, raising the question of whether this marks a temporary pause or the end of the recent upward trajectory.

Key Drivers Behind the Euro's Recent Ascent

First, the widening divergence in economic expectations between Europe and the United States continues to provide fundamental support for the euro. August economic data from the eurozone showed a broad-based recovery: the manufacturing PMI flash estimate climbed to 52.8, its highest level since May 2022, while the services PMI held steady at 51.7. The composite PMI registered 52.1, reaching a nine-month high. In contrast, core U.S. indicators such as non-farm payrolls and retail sales have been steadily weakening, with the gap between the Citi Economic Surprise Indexes for Europe and the U.S. widening further.

Second, the interest rate differential is favoring the euro, with the two-year German-U.S. yield spread having tightened by 30 basis points since July, propelling EURUSD higher. Money markets are pricing in a 95% probability of a European Central Bank rate hike in September, making the move all but certain. Meanwhile, the odds of a Federal Reserve hike stand at just 35%, and with U.S. economic data continuing to soften, a September pause appears highly likely. Given the November midterm elections, if the Fed refrains from hiking in September, an October move also seems improbable—historically, the Fed has never initiated a tightening cycle at the FOMC meeting immediately preceding congressional elections.

Third, growing concerns over dollar creditworthiness are prompting long-dollar positions to unwind. The catalyst for the euro's breakout above its 200-day moving average was the U.S. Treasury's announcement of a doubled buyback program for long-dated bonds. This move has fueled anxieties about U.S. debt sustainability and the credibility of the dollar-based system, triggering a squeeze on crowded euro shorts.

Can the Upside Momentum Persist?

The aforementioned bullish factors are expected to continue underpinning the euro's strength over the medium to long term. Options market pricing reflects this sentiment, with the EURUSD risk reversal climbing and the 3-month 25-delta risk reversal reaching its highest level since March, signaling that the market maintains a constructive outlook on the euro.

However, near-term correction risks are intensifying, with several headwinds capping upside potential.

On one front, elevated energy prices are weighing on the eurozone's terms of trade. Brent crude remains above $90 per barrel, and European natural gas prices stay elevated. Additionally, there is a possibility of further escalation in the Iran situation before the U.S. midterm elections.

On another front, political uncertainty in Germany is limiting upside scope. September brings autumn state elections in Germany, and if the Alternative for Germany (AfD) party performs stronger than expected, it could heighten European political risk and exert downward pressure on the euro.

Concluding Assessment

1. While the medium-term bullish narrative for the euro remains intact—supported by outperforming European economic data, ECB tightening, and concerns over U.S. debt undermining dollar credibility—much of this positive news may already be priced in. A sustained one-way rally through 1.18 appears unlikely without additional fresh catalysts.

2. Persistently high energy prices are capping the euro's upside. On the technical front, EURUSD may first need to retrace toward the 1.16-1.1630 zone. It would be prudent to wait for a pullback before establishing long positions.

3. The key event this week is the Jackson Hole symposium, themed "Financial Innovation: Implications for Payments and Policy." Fed Chair Warsh (speaking at 10:00 PM Beijing time on August 28) is unlikely to offer hints regarding the September meeting, suggesting limited market volatility. Overall, we expect subdued price action to persist through the week.