Euro slides to two-month low as US-EU yield gap widens

The euro slid to a two-month low of $1.1507 against the dollar on Tuesday as diverging monetary policy paths between the Federal Reserve and the European Central Bank pushed the US-EU yield gap to its widest in three months.

"The yield differential continues to drive EUR/USD lower as markets price in a more hawkish Fed relative to the ECB," analysts at Danske Bank said in a note. "We see scope for further downside toward $1.14 in the near term."

The move extended losses from Friday after a US nonfarm payrolls report showed 172,000 jobs were added in May, far exceeding consensus estimates. Markets now price a more than 70 percent chance the Fed will raise rates in December, up from 45 percent a week ago, according to the CME FedWatch tool. The 10-year US Treasury yield rose 8 basis points to 4.62 percent, while the German bund yield edged up 2 basis points to 2.84 percent, widening the spread to 178 basis points.

The divergence threatens to keep the euro under pressure through the second half of the year. Capital Economics expects the Fed to deliver two 25-basis-point rate hikes in 2026, while the ECB faces headwinds from a weaker eurozone economy and elevated energy costs tied to the Iran conflict. The ECB's next policy decision is scheduled for July 16.

The dollar's broad strength pushed other major currencies lower as well. Sterling fell to a three-week trough of $1.33165, while the Australian and New Zealand dollars each slid to two-month lows of $0.7016 and $0.5779, respectively. The dollar index climbed to 105.82, its highest since early April.

Rate Differentials Drive the Trade

The yield advantage favoring the US has been the primary driver of EUR/USD weakness since April. The last time the spread exceeded 180 basis points was in March, when the euro fell to $1.1420 before rebounding on ECB hawkish commentary. This time, the ECB has offered little pushback, with President Christine Lagarde signaling caution on further tightening as the eurozone manufacturing PMI remains in contraction territory at 48.9.

"The combination of a strengthening US labor market and the ongoing energy price shock makes policy tightening by the Fed increasingly probable," said Jonas Goltermann, chief markets economist at Capital Economics. "We now expect the FOMC to deliver two 25-basis-point rate hikes later this year."

Yen Intervention Zone Tested

The dollar's rally also pushed the yen to 160.29 per dollar, erasing all gains from Japan's 11.7 trillion yen intervention just over a month ago. The Bank of Japan is expected to raise interest rates at its June meeting unless a sharp escalation in the Middle East conflict upends markets, sources told Reuters. Still, the BOJ's ultra-loose stance relative to the Fed leaves the yen vulnerable to further weakness.

"The yen remains under pressure due to the persistent interest rate disadvantage, with the Bank of Japan still slow to normalize policy despite hawkish shifts at other central banks," said David Meier, an economist at Julius Baer.

This article is for informational purposes only and does not constitute investment advice.