06.10.202615:30 Forex Analysis & Reviews: Euro turns funding currency

The dollar had been charging forward like a train people were reluctant to board — and now that train is braking hard. EUR/USD turned up from local lows, and the greenback's rally toward its strongest level of the year has temporarily lost steam.

US dollar dynamics

Investors flock to the dollar because the US offers higher yields, a resilient economy, and a safe-haven status amid geopolitical uncertainty. The futures market has been pricing in a more aggressive Fed path than other major economies, which helps explain why EUR/USD spent so long under pressure.

But the pace of the rally worked against itself. Markets had priced in more than 80 basis points of Fed hikes through September 2027, including one move as soon as this year — a level that proved excessive. Repricing those expectations triggered the correction, and the greenback briefly resembled a sprinter who misjudged the distance.

A sharp rise in the dollar risk premium forced speculative positions that bet on further appreciation to stop out. Traders preferred to lock in profits rather than add to positions at the peak, which helped EUR/USD bounce. At the same time, the euro is turning into the funding currency for carry trades, reflecting a growing premium for political risk.

Cost of insuring against a French default

A key negative for the single currency remains France's budget crisis. Yields on French 10-year bonds sit near 2002 highs, while government debt has reached 119% of GDP and is projected to climb to 122%. Paris plans to borrow a record €340 billion in 2027 — a prospect that is already showing contagion in yields across Greece, Italy, and Spain. The euro is creaking like ice under the weight of the French budget, and even the current EUR/USD bounce does not remove that burden.

Turbulence in France's debt market is also cooling rate expectations for the ECB. The central bank is likely to pause in October and limit itself to one final 25-bp deposit-rate hike in December, despite inflation coming in hotter than forecast. Tighter financial conditions reduce the urgency for further moves.

The political backdrop adds another layer of uncertainty. French presidential candidate Marine Le Pen has urged the ECB to step in to lower borrowing costs and free up "tens of billions of euros" for defense and technology investment. Rival Jean-Luc Melenchon dismissed her plan as pandering to speculators that would only worsen deficits and debt. The ECB's mandate bars direct government financing, so Le Pen's request is likely to be rejected.

Is this breather enough to reverse the trend, or has the market merely taken a breather before another dollar leg higher?

Technically, the daily chart shows a bounce in EUR/USD. Rebounds from 1.1275, 1.13, or 1.134 would be a reason to sell.