The euro and British pound attempted to recover against the US dollar on Friday, yet the modest improvement in both currencies concealed a much more complicated shift taking place across European foreign-exchange markets. Investors are no longer deciding whether the European Central Bank and Bank of England will cut interest rates, but whether renewed energy inflation could eventually force either institution to tighten policy again, even as economic growth remains fragile.

The euro edged higher after falling to a nine-day low, while sterling also recovered modestly from its recent weakness. Neither move represented a decisive rejection of the stronger dollar, which remained supported by elevated US Treasury yields and demand for safer assets, but both currencies benefited from the growing belief that European interest rates may need to remain high for considerably longer than markets expected only a few weeks ago.

This creates an unusual currency environment. Higher interest-rate expectations would normally strengthen the euro and pound, yet the reason those expectations are rising is precisely what threatens both economies: oil prices have returned to around $100 a barrel, transportation costs are climbing and investors are once again discussing the possibility of stagflation.

The euros uncomfortable rate advantage

The European Central Bank kept its deposit rate unchanged at 2.25% on Thursday after raising it in June, but it left the door open to another increase as policymakers assess whether the latest energy shock will spread into wages, services and broader consumer prices. Traders are now assigning a very high probability to a quarter-point increase in September and are also pricing the possibility of another move before the end of the year.

Under normal circumstances, such a rapid repricing would provide significant support for the euro. Higher expected returns on euro-denominated bonds make the currency more attractive, while the prospect of tighter monetary policy can reduce the relative appeal of the dollar.

The problem is that the eurozone is not receiving this interest-rate support because its economy is accelerating. It is receiving it because imported energy is becoming more expensive again.

Europe remains particularly vulnerable to a sustained increase in oil and gas prices because it imports a large portion of its energy requirements. That means the same shock pushing the ECB toward higher rates is also weakening household purchasing power, raising manufacturing costs and threatening a region that was already struggling to generate convincing growth.

The latest ECB survey reflects this tension. Economists expect eurozone inflation to average 2.7% in 2026 before easing to 2.2% next year, while the growth forecast for this year has been reduced to only 0.6%. The euro is therefore being offered higher rates alongside weaker growth, a combination that can support a currency temporarily but rarely produces a comfortable long-term rally.

Sterling carries a different kind of strength

The pound faces many of the same pressures, but its position looks somewhat less fragile. British inflation is also expected to rise as expensive energy and disrupted shipping feed into transport, utility and business costs, while Bank of England officials have repeatedly warned that they remain prepared to raise rates if inflation expectations become more deeply embedded.

Markets currently see a meaningful possibility of one Bank of England increase before the end of the year, although economists remain more cautious and many expect the central bank to leave borrowing costs unchanged. Bank of England policymaker Catherine Mann has said she would support tighter policy if the inflation outlook deteriorates, while Governor Andrew Bailey has made clear that renewed rate cuts are not currently under discussion.

Sterlings relative advantage is that investors have been more willing to believe the UK economy can absorb tighter policy without falling immediately into a deeper slowdown. The pound had already reached a 10-month high against the euro in June, and the euro has repeatedly struggled to establish a durable recovery against the British currency.

That does not make sterling immune to the energy shock. Britain imports fuel, remains exposed to global shipping costs and is already facing elevated inflation expectations. Yet the pound enters the current period with stronger market momentum and a clearer interest-rate premium than the euro, making it the more convincing of the two European currencies for now.

The dollar remains the real obstacle

The more important comparison today may not be between the euro and sterling at all, but between both currencies and the US dollar.

The dollar has gained close to 0.9% this week, its strongest weekly performance since May, as rising oil prices and higher Treasury yields revived expectations that the Federal Reserve could tighten policy again. The US 10-year yield recently climbed to an 18-month high, while the 30-year yield approached levels not seen in nearly two decades.

This places the euro and pound in a difficult position. Both may benefit from higher domestic interest-rate expectations, but the dollar is receiving the same support while also benefiting from its role as the markets preferred refuge during periods of geopolitical stress.

The United States is also less vulnerable than Europe to imported energy inflation because it is a major oil and gas producer. Higher crude prices still hurt American consumers and can push inflation upward, but Europe experiences the shock more directly through its trade balance, industrial costs and dependence on external supplies.

As long as oil remains close to $100 and US yields stay elevated, recoveries in both EUR/USD and GBP/USD may struggle to develop into sustained advances.

The most revealing exchange rate may be EUR/GBP

Investors often analyse the euro and sterling primarily against the dollar, but the euro-pound exchange rate may provide the cleaner verdict on their relative strength.

Both Europe and Britain are facing the same broad global shock, including higher fuel prices, more expensive shipping and the possibility of tighter monetary policy. Comparing them directly removes much of the dollars safe-haven influence and reveals which regional economy investors believe is better equipped to manage the pressure.

Sterling has generally held the upper hand in that contest. If the pound continues outperforming the euro while both currencies struggle against the dollar, the message would be that investors are not rejecting Europe as a whole, but are distinguishing between two different levels of vulnerability.

A sustained euro recovery against sterling would require more than the promise of ECB rate increases. It would probably need evidence that eurozone activity is stabilising, energy prices are no longer worsening the regions trade position and the ECB can control inflation without placing an already weak economy under excessive pressure.

What investors should watch next

The immediate direction of both currencies will depend on three developments: whether oil remains above $100, whether European bond yields continue rising and whether upcoming business-activity data confirms that economic growth is holding up.

For the euro, the key test is whether higher rate expectations can outweigh Europes exposure to the energy shock. A further rise in German bond yields accompanied by improving economic data could allow the currency to recover, but rising yields alongside weaker activity would make the policy story look increasingly stagflationary.

For sterling, attention will turn toward whether markets continue increasing their expectations for a Bank of England move and whether the UK economy maintains its recent relative advantage over the eurozone. The pound may remain stronger against the euro even if it struggles to make meaningful progress against the dollar.