The divergence between the European Central Bank and the Federal Reserve is widening, and traders are once again betting on the euro breaking through the key psychological level of 1.2

As expectations deepen regarding the divergence in monetary policy paths between the European Central Bank and the Federal Reserve, traders are re-betting that the euro will rise to the key psychological level of 1.20 against the dollar.

Last week's weak U.S. non-farm payroll data intensified market expectations for deep rate cuts by the Federal Reserve, further weakening the dollar. Meanwhile, the European Central Bank has paused its easing cycle, with the money market assigning only a one-third probability of a rate cut before December.

On Tuesday, the euro rose 0.1% to 1.1780 against the dollar, reaching its highest level since July 24, before giving back some gains, currently at 1.173. French Prime Minister Élisabeth Borne lost a no-confidence vote in parliament, but the euro largely ignored the political risk.

George Saravelos, Global Head of FX Research at Deutsche Bank, believes that the cyclical support for the dollar is deteriorating, and the significant narrowing of the euro-dollar interest rate differential has brought the fair value of euro/dollar back to the 1.18-1.20 range. Technical indicators are also turning bullish, with the monthly chart forming a bullish engulfing pattern.

Divergence in Monetary Policy Drives Euro Rebound

Activity in the options market clearly reflects bullish sentiment among investors. Data shows that the so-called "risk reversal indicator" indicates a bullish bias for the euro across all maturities. According to data from the Depository Trust & Clearing Corporation (DTCC), since last Friday, one-third of bullish bets target the euro breaking above 1.20.

Thomas Bureau, Co-Head of FX Options at Société Générale, stated that the next key resistance level for the euro is 1.18 USD. He believes that once this level is breached, it could trigger a large number of stop-loss orders, accelerating the upward momentum of the euro.

U.S. macroeconomic data is key to driving this round of market expectations. Following last week's non-farm payroll data, the upcoming benchmark revision of U.S. employment data later today, if negative again, could further support the euro. Market expectations for decisive action from the Federal Reserve are heating up.

In this regard, George Saravelos added:

"It is clear that further rate cuts by the Federal Reserve from current levels will increase the motivation for foreign investors to hedge their dollar assets."

Limited Impact of Political Risk, Technical Indicators Turn Bullish

Despite the turmoil in French politics, the euro has shown considerable resilience. On Monday, after French Prime Minister Élisabeth Borne lost the no-confidence vote in parliament, the euro still rose by 0.4%, while the cost of hedging against euro strength also increased.

Analysts at Danske Bank wrote in a report that the widening spread of French government bond yields may limit the euro's upside potential, but they still believe the euro is undervalued against the dollar. Holger Schmieding, Chief Economist at Berenberg Bank, stated that although France may face the risk of a credit rating downgrade, given its current account is close to balance, the likelihood of a full-blown crisis remains low:

"European Central Bank President Christine Lagarde must be cautious in her wording this Thursday, neither hinting that the ECB may ultimately rescue unrepentant fiscal sinners nor taking too harsh a stance to avoid disturbing the markets that still have confidence in France."

From a technical analysis perspective, multiple indicators are turning favorable for the euro. A so-called "bullish engulfing" pattern has formed on the monthly chart, suggesting that the euro may retest the high of 1.1829 set in July. In the short term, the market sentiment index, known as the "fear and greed index," shows that euro bulls are in their strongest position in over two months