Middle Eastern conflict severely impacts the European economy! The euro records its worst quarterly performance since 2024, with bearish sentiment rising to a four-year high.

Fighting in the Middle East is driving up energy prices and reshaping the foreign exchange market landscape. The euro’s quarterly decline is expected to be the worst since 2024. Europe’s high dependence on energy imports is once again laid bare, casting a shadow over the region’s economic outlook. The options market shows that demand for downside protection on the euro hit a four-year high this month, with bearish sentiment rising to a near multi-year peak.

The euro against the U.S. dollar has fallen by about 2% this quarter and is currently around $1.15. In just March alone, it has dropped 2.5%, the steepest monthly decline since July 2024. This stands in stark contrast to the strong move in late January, when the euro broke above $1.20 and touched a near five-year high. Morgan Stanley strategists David Adams and his team expect that, in the near term, the euro could fall further to $1.13.

With oil prices continuing to climb and the Strait of Hormuz disrupted, currency traders are reverting to the trading logic from the 2022 Russia-Ukraine war—when European markets were badly hit and the U.S. dollar surged strongly. At the same time, the currency market has fully priced in the ECB’s expectations for three rate hikes this year, and the shift is striking compared with just a few weeks ago, when the probability of rate cuts was still being priced at 35%.

The options market shows bearish sentiment is gaining momentum

Signals from the derivatives market are more pessimistic than analysts’ forecasts. A Bloomberg survey shows analysts’ target price for the euro by year-end is $1.20, but the path implied by options contracts is far weaker than that. Earlier this month, demand for downside protection on the euro hit a four-year high. Previously, traders had been consistently paying steep premiums to back bullish positions; now, that preference has completely faded, and market sentiment has shifted to neutral.

Looking at specific currency pairs, bearish options on the euro versus the Japanese yen are outweighing bullish positions by nearly four to one. Positions versus the Swiss franc and the Australian dollar are also skewed bearish, though the magnitude is relatively milder. However, the euro is not weakening across all currency pairs—according to this month’s data from the Depository Trust & Clearing Corporation (DTCC), traders are more than four times as likely to bet on gains in the euro versus the British pound than they are to bet on declines. Euro market sentiment is showing a clear divergence across different currency pairs.

Energy shock puts the ECB back in a policy dilemma

Rising oil prices are pushing the European Central Bank into a tricky policy predicament. ING noted that while rate hikes typically support a currency when the economy is strong, constraints on supply triggered by the Middle East situation break that logic—during the crisis in the Gulf, reducing overseas investment will tighten global financial conditions, and currencies that are sensitive to growth, such as the euro, will be hit first.

Germany’s inflation data shows inflation has climbed to its highest level in a year, driven by energy prices. The situation facing the ECB is similar to 2022: energy-driven inflation and a slowdown in economic activity are occurring at the same time, leaving extremely limited policy room.

Fiscal optimism fades, growth expectations are cut

The fiscal tailwinds that previously supported the euro are fading. Market optimism about Germany’s shift in fiscal policy and the expansion of defense spending has clearly cooled. The OECD has also simultaneously lowered its growth forecasts for the euro area, and Germany and Italy are considering cutting their respective official growth forecasts.

This means that multiple tailwinds that pushed the euro to near five-year highs at the start of the year—expectations for fiscal expansion and the logic of a weaker U.S. dollar—have been offset one by one by the energy shock within just a few weeks.

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