By Linh Tran, Market Analyst at XS.com
EURUSD has recently pulled back from its peak near the round-number level of 1.1800, reflecting a more cautious investor sentiment after a period in which the euro recovered significantly against the US dollar. At this stage, the key driver of EURUSD lies in the fact that the USD is gradually losing its advantage as the US easing cycle approaches and markets increasingly lean toward a scenario of lower US interest rates in the coming year.
The interest rate differential between the Fed and the ECB is narrowing. The Fed has brought its target rate down to 3.50% – 3.75%, and recent Fed communications continue to stress that policy remains “restrictive” but still leaves room for further cuts, particularly as the labor market shows signs of softening and employment risks are being mentioned more frequently.
Meanwhile, the ECB is holding the deposit facility rate at 2.00%, alongside the MRO at 2.15% and the marginal lending facility at 2.40%. Although ECB rates remain lower than those of the Fed in absolute terms, the direction of EURUSD is ultimately driven by future expectations. If investors believe that the Fed will continue cutting rates and move toward neutral more quickly than the ECB, the USD is likely to weaken on a relative basis, providing support for EURUSD.
Eurozone inflation in November 2025 was recorded by Eurostat at around 2.1%, very close to the ECB’s 2% target. By contrast, US inflation remains around 3%, meaning the USD no longer retains the same advantage it once had. Inflation being close to target limits the ECB’s ability to turn more hawkish; however, it also helps support confidence in the euro and contributes to overall currency stability.
On the US side, widely followed estimates suggest inflation is still hovering around ~3% year-on-year and is unlikely to return to 2% quickly. This forces the Fed to carefully balance efforts to support the labor market without reigniting inflation. This tension creates periods in which the USD reacts sharply to incoming data, but the broader trend remains driven by market expectations. As markets increasingly believe that the Fed is moving toward a neutral policy stance, the USD gradually loses its interest rate advantage relative to the euro.
At this point, the Eurozone does not need to outperform expectations; it simply needs to avoid disappointing. As long as interest rate differentials continue to narrow and US growth momentum fades, EURUSD can continue to extend its upward trend.
Recent activity indicators in the Eurozone suggest an economy that is “sluggish but not collapsing,” which is sufficient to prevent the euro from being sold aggressively on recession fears. In other words, the current foundation for the euro is based on stable expectations rather than strong growth acceleration.
When the Fed transitions from a tightening phase to an easing cycle, markets typically experience two parallel developments. First, capital that had been parked in USD assets due to high yields gradually shifts toward riskier assets or other currencies, reducing demand for the dollar. Second, after a prolonged period of USD strength, markets tend to accumulate substantial long-USD positioning; when policy expectations shift, these positions are partially unwound, generating significant selling pressure on the USD. As a result, EURUSD sometimes rises not because Eurozone data materially improve, but simply because the USD is being sold as markets reprice US interest rate expectations and financial conditions.
Looking ahead, if the Fed continues to cut rates cautiously while the ECB maintains a stable policy stance, EURUSD is likely to remain elevated or edge higher. However, price volatility may increase around major US data releases such as CPI and employment reports. Conversely, if US inflation proves persistent and forces the Fed to keep rates higher for longer, the USD could strengthen again, placing corrective pressure on EURUSD.
EURUSD reflects the relative expectations for interest rates between the two economies: the currency whose expected yields decline more rapidly tends to lose its advantage. At present, the medium-term bias of EURUSD is gradually tilting in favor of the euro as the US dollar continues to lose its relative edge.