Hedge funds buck the trend: How speculative strategies catalyze the rise of the euro.

The euro has risen by almost 6% since April, mainly due to hedge funds eliminating their short positions and shifting to more optimistic bets. According to CFTC data, in mid-April, leveraged traders were the largest net sellers of the currency since the end of 2021. However, by the end of August, they had become the most bullish on the euro in over a year. This shift occurred because the market began perceiving a softer stance from the U.S. Federal Reserve. The currency has dropped 1.7% from last month’s peak. According to traders, market orders are no longer as favorable for the euro as they were during the summer. Now, euro supply exceeds demand, and fast traders looking to exit their short positions are targeting levels below $1.10.

The market was in a wait-and-see mode for a while. First, the U.S. employment data was released, followed by the presidential debate and the upcoming Federal Reserve meeting. When there’s consolidation during a trend, it usually leads to a correction and raises questions about whether the market dynamic has shifted. This is the challenge euro traders are facing now: a slight change in the market narrative.

Uncertainty surrounding the U.S. elections in November is likely to keep the dollar stable. Bulls can’t rely solely on the Federal Reserve for long. There need to be new factors from the Eurozone for the euro to reach $1.15. It’s hard to imagine a scenario where bets on a softer stance from the Federal Reserve increase without the same happening for the European Central Bank (ECB).

Some market participants already believe that the ECB is lagging because inflation forecasts don’t align with current swap prices. This could mean that the Governing Council may need to ease policy sooner than expected, adding more pressure on the euro. Forecasts may change if the ECB’s updated inflation projections on Thursday require it.

There are already discussions on this matter. A strategy head predicts that the euro could fall to $1.02 by the end of the year if markets bet that the central bank will cut rates at the next three meetings, including the possibility of a half-point cut.

Another important question is whether the euro is the best tool to express a negative outlook on the dollar. Yes, as long as volatility remains low, long euro-dollar positions could work. But there are risks associated with the possibility of a softer stance from ECB President Christine Lagarde today, political uncertainty in France and Germany, and weak economic data from China. Sometimes it’s enough for the market to begin questioning the scale or validity of the latest trend to change direction.

And what if inflation changes its course? Bank of Canada Governor Tiff Macklem pointed out that changing global trends are likely to create more supply shocks, which could raise prices and increase inflation volatility. This should theoretically support the euro, as the ECB’s mandate focuses on price stability, while the Federal Reserve also considers the labor market. However, higher inflationary pressure would create a new market where the dollar wouldn’t be sold off without careful consideration.

For now, attention is on the ECB’s decision. A quarter-point rate cut is expected, and if it doesn’t happen, it would be a big surprise. Currently, markets are pricing in a 36% chance of consecutive rate cuts in October, and options indicate that this is one of the most anticipated meetings of the year. A slight shift in market sentiment could begin to accelerate.