In-depth Interpretation! The Mystery of the Fluctuations in the Exchange Rate of the Euro against the US Dollar

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The fluctuations in the EUR/USD exchange rate often puzzle market participants. However, these price movements are not mysterious phenomena. There is a clear logical framework behind them. Three core forces collectively shape the ultimate direction of the exchange rate.

These three decisive factors are:

• Economic fundamentals
• Central bank monetary policy divergences
• Geopolitical events and market sentiment

Understanding how these interact is key to mastering exchange rate dynamics.

Key Points

• The EUR/USD exchange rate is influenced by three primary forces.
• Economic fundamentals determine the long-term trend.
• Central bank monetary policies shape the medium-term direction.
• Geopolitical events and market sentiment trigger short-term fluctuations.
• Understanding these factors can help better analyze exchange rate changes.

Economic Fundamentals: Comparing U.S. and Eurozone Strength

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Economic fundamentals are the cornerstone of a currency’s long-term value. The differences in economic growth, inflation, and labor market performance between the United States and the Eurozone directly lay the foundation for the long-term trend of the EUR/USD exchange rate. The stronger an economy, the more solid the support for its currency’s value.

Economic Growth Differences

Economic growth is the most intuitive indicator of economic health. Strong economic growth typically attracts international capital inflows, increasing demand for the domestic currency. Recent data shows clear divergence in growth between the U.S. and the Eurozone.

The U.S. economy has demonstrated strong resilience. For example, the U.S. GDP growth rate reached 3.80% in the second quarter of 2025. In contrast, the Eurozone’s GDP growth rate for the same period was only 0.1%. This significant growth gap naturally provides robust support for the USD.

The Purchasing Managers’ Index (PMI) also reflects this trend. The Eurozone manufacturing PMI fell to 49.80 in September 2025, remaining in contraction territory. Although service sector expansion lifted the composite PMI slightly to 51.2, manufacturing weakness continues to drag down the economy.

Inflation Levels

Inflation levels directly influence central banks’ interest rate decisions, making them a key variable in exchange rate fluctuations. Since early 2021, both the U.S. and Eurozone have experienced significant inflation surges.

Historical data shows that U.S. inflation rose earlier and more strongly. Although Eurozone inflation briefly surpassed the U.S. at the end of 2022, the sources and evolution paths of inflation pressures in the two economies differ, leading to varying market expectations.

According to the latest data, the Eurozone’s inflation situation remains complex.

While the 2.2% year-on-year increase is slightly above the European Central Bank’s 2.0% target, the core inflation rate (excluding volatile food and energy) rose to 2.4%, indicating persistent underlying price pressures. This stubborn inflation complicates the ECB’s policy choices.

Labor Market Performance

The labor market is a barometer of the economy. A healthy labor market signals strong consumer spending potential and an optimistic economic outlook. In this regard, the U.S. labor market is generally more robust than the Eurozone’s.

The Eurozone’s labor market shows significant internal disparities, with an overall high unemployment rate. Data from August 2025 shows the Eurozone’s overall unemployment rate at 6.3%, with countries like Spain reaching as high as 10.3%.

In contrast, while recent U.S. non-farm payroll data showed signs of cooling (only 22,000 jobs added in August 2025, far below expectations), the overall unemployment rate remains at historic lows. The relative strength of the labor market is a key factor influencing investor confidence in the USD versus the EUR, ultimately reflected in the EUR/USD exchange rate trend.

Monetary Policy Divergence: Core Driver of EUR/USD Movements

If economic fundamentals are the “slow variable” for exchange rates, central bank monetary policies are the “fast variable” and core driver of medium- to short-term trends. Any divergence in policy between the Federal Reserve (Fed) and the European Central Bank (ECB) is quickly amplified by markets, directly impacting EUR/USD fluctuations.

Interest Rate Decisions and Paths

Interest rates are the price of money. The rate differential, or “spread,” between the two central banks is a direct signal for capital flows. Capital tends to flow toward currencies with higher interest rates to seek better returns.

Core Logic: When U.S. interest rates are higher than Eurozone rates, holding USD becomes more attractive, prompting investors to sell EUR and buy USD. This process increases USD value and depresses EUR value.

Currently, there is a clear gap between the Fed’s and ECB’s policy rates. The Fed set the federal funds rate at 4.00%–4.25% in September 2025, while the ECB’s main refinancing rate is 2.15%.

This significant rate differential provides solid support for the USD. As long as this gap persists, the USD holds a natural advantage over the EUR.

Central Bank Forward Guidance

Markets trade on expectations. Thus, central bank officials’ speeches and statements, or “forward guidance,” are sometimes more significant than actual rate changes. These statements reveal future policy paths, shaping market expectations.

Currently, market predictions for the two central banks’ rate cut paths have diverged:

• European Central Bank: Markets generally believe its rate-cutting cycle is nearing its end. Swap market data indicates traders expect at most one more rate cut by year-end.
• Federal Reserve: Investors expect more aggressive rate cuts from the Fed. Market pricing suggests policy rates could fall below 3% by the end of 2026, which is more dovish than the Fed’s own projections.

The Fed Chair’s recent remarks reinforce this dovish stance. He explicitly stated: “The rising downside risks to employment have altered our assessment of the balance of risks.” This suggests the Fed is willing to move toward a more neutral policy stance faster to support the labor market.

In contrast, the ECB is more cautious. Despite lowering inflation forecasts, it emphasizes that policy will be data-dependent rather than following a preset path, aiming to stabilize inflation at 2%.

This divergence in expectations leads markets to anticipate a “weaker USD, stronger EUR” scenario, influencing current exchange rate fluctuations.

USD Index and Passive Appreciation

The USD Index (DXY) measures the USD’s value against a basket of currencies. Understanding its composition helps clarify the unique “seesaw” relationship between EUR and USD.

The EUR holds a dominant position in the USD Index (DXY), accounting for a 57.6% weight.

This means any movement in the EUR significantly impacts the DXY’s direction. When the EUR weakens due to its own economic softness or dovish monetary policy, the DXY can “passively” rise even if USD fundamentals remain unchanged. Over the past six months, the DXY has only declined by 0.54%, showing strong resilience largely due to the EUR’s relative weakness.

Balance Sheet Operations

Beyond interest rates, central banks’ balance sheet sizes (via quantitative easing, QE, or quantitative tightening, QT) are another powerful tool affecting money supply.

• Quantitative Tightening (QT): Central banks sell assets (e.g., government bonds), withdrawing money from the market, reducing money supply, and theoretically strengthening the currency.
• Quantitative Easing (QE): Central banks purchase assets, injecting money into the market, increasing money supply, and theoretically weakening the currency.

In this regard, the Fed’s actions are far more aggressive than the ECB’s. Since May 2022, the Fed has reduced its balance sheet from a peak of nearly $9 trillion to about $6.7 trillion through QT.

Meanwhile, the ECB has been more gradual in reducing its Asset Purchase Programme (APP) and Pandemic Emergency Purchase Programme (PEPP). The chart above shows the ECB’s balance sheet size has remained relatively stable recently. This “tight vs. loose” divergence further reinforces the USD’s strength from a money supply perspective.

Geopolitical Events and Market Sentiment: Catalysts for Exchange Rate Volatility

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Economic data and central bank policies set the baseline direction for exchange rates, but geopolitical risks and sudden market sentiment shifts act as “catalysts” igniting short-term volatility. In the face of uncertainty, investors’ panic or risk-averse behavior can rapidly alter capital flows, amplifying exchange rate fluctuations.

USD’s Safe-Haven Status

The USD holds a unique position in the global financial system. During times of market turmoil, the USD often becomes the preferred asset for investors. This “safe-haven status” stems from its role as the world’s primary reserve and transaction currency.

During crises, global demand for USD liquidity surges sharply. Investors sell riskier assets and turn to USD cash or U.S. Treasuries for safety.

The early March 2020 COVID-19 pandemic outbreak is a prime example. Market panic led investors to aggressively buy USD, causing its value to soar while other major currencies, like the GBP, plummeted. History has repeatedly confirmed this:

• 2008: After the global financial crisis erupted, the EUR/USD exchange rate fell sharply from a high of about 1.60 as capital flooded into the USD.

Eurozone Geopolitical Risks

Unlike the USD’s global safe-haven status, the EUR is more vulnerable to direct impacts from geopolitical risks in its region. Any conflict or political instability in Europe undermines investor confidence in the Eurozone’s economic outlook, putting pressure on the EUR.

The 2022 Russia-Ukraine conflict is a stark example. The conflict dealt a heavy blow to the EUR due to:

• Energy Dependency: Europe’s high reliance on Russian energy triggered a severe energy crisis, raising fears of an economic recession.
• Economic Shock: The conflict exacerbated inflation in Europe and drove its terms of trade to historic lows.
• Capital Outflows: Uncertainty prompted capital to flee Europe in favor of safer assets like the USD.

Global Risk Event Impacts

Whether it’s a financial crisis, large-scale public health event, or regional conflict, any event capable of triggering global panic becomes a key variable affecting the EUR/USD exchange rate. These events rapidly shift the balance of power by sparking risk-averse market sentiment.

During risk events, markets often amplify the USD’s strength while exposing the EUR’s vulnerabilities. Investors prioritize asset safety over yield, leading to capital flows from the Eurozone to the U.S. This sentiment-driven capital movement is a critical component in understanding short-term exchange rate volatility.

In summary, EUR/USD exchange rate fluctuations are not driven by a single factor. Their trajectory results from the interplay of three pillars:

• Economic Fundamentals: Shape long-term trends.
• Monetary Policy: Guide medium-term directions.
• Market Sentiment: Act as short-term catalysts.

Current market views are sharply divided. Optimists believe U.S. structural issues will weaken the USD, with some banks predicting the exchange rate will rise to the 1.20–1.22 range. However, pessimists point to the Eurozone’s lackluster economic recovery, suggesting downward pressure on the exchange rate. This bullish-bearish tug-of-war, combined with a low implied volatility of 6.25%, indicates the exchange rate may oscillate within a range near key support levels (e.g., 1.1600) in the short term.

FAQ

Which factor has the greatest impact on the EUR/USD exchange rate?

The three factors play roles on different time scales:

• Long-Term Trends: Driven by economic fundamentals.
• Medium-Term Directions: Dominated by central bank monetary policies.
• Short-Term Fluctuations: Catalyzed by market sentiment and geopolitics. They work together, and no single factor is absolutely “most important.”

How can individuals apply this analysis?

Understanding these core factors helps market participants interpret financial news. It provides a logical framework for assessing exchange rate risks and judging long-term trends. This is not direct investment advice but a knowledge base to build a more comprehensive market understanding.

What is the USD Index (DXY)?

The USD Index (DXY) measures the USD’s value against a basket of six major currencies. It acts like a weighted score, reflecting the USD’s overall strength.

The EUR has the largest weight (57.6%), so its movements significantly impact the DXY.

Why does the exchange rate fluctuate sharply even when policies are stable?

Because markets trade on expectations. Even if central bank policies remain unchanged, an unexpected economic data release (e.g., employment reports) or breaking news can quickly shift investor sentiment. This change in sentiment directly triggers capital flows, leading to short-term exchange rate volatility.