By Samer Hasn, Senior Market Analyst at XS.com
EUR / USD moves sideways so far today after plunging to the lowest levels since November after two days of notable declines.
The euro might be prone to further severe declines that could bring it closer to parity with the dollar, amid concerns about the return of an energy crisis and inflation concerns. While rising US Treasuries yield with a considerably low amount of fear in their market and knowing that the dollar has even more room to the upside, puts the dollar ahead of a significant challenge, just like what we said in 2022.
Closing the Strait of Hormuz and targeting energy infrastructure in the Middle East amid the raging war with Iran sent oil and gas futures soaring, threatening a return to an energy crisis and waves of inflation in the eurozone.
Inflation had already started to rise even before the war. Eurozone inflation rose unexpectedly to 1.9% in February. The situation is further complicated by low gas storage levels and recent attacks on Qatari energy infrastructure, leaving policymakers to weigh the risk of energy-driven inflation against the potential for geopolitical uncertainty to dampen overall economic investment and growth, per The Wall Street Journal.
The European Central Bank had previously stated that its policy was in a “good place.” However, with WTI crude oil reaching its highest level since 2023 and the settlement for Dutch TTF Natural Gas Futures nearly doubling from Friday’s close, there is potential for a hawkish policy shift if these shocks prove lasting.
The recent developments have led to an increase in eurozone government bond yields, which may dampen hopes for further easing from the European Central Bank (ECB). Additionally, the yield spread between US and German bonds is narrowing, which could have supported the euro. However, the prospect of prolonged high interest rates in the US, a resilient bond market, and the eurozone’s vulnerability to rising inflation and interest rates are putting significant bearish pressure on the euro.
The ICE BofAML U.S. Bond Market Option Volatility Estimate Index (MOVE) is still hovering near its 2021 lows, even after the recent spike observed on Friday and yesterday. This trend signals significant investor confidence in the U.S. Treasury market still in play, which is contributing to rising yields and fueling the dollar rally.
The US economy has demonstrated resilience in the face of higher borrowing costs, whereas the eurozone has struggled. Multiple surveys published over the past few years, following the inflation surge, indicate that the eurozone has been unable to sustain growth in this economic environment. This situation threatens to lead to a prolonged decline in the euro’s value.
These surveys, including S&P Global PMI reports, GfK Consumer Climate, ifo Business Climate, and Sentix Investor Confidence, all reported that rising inflation and higher rates caused activities across the economy to contract.
What next?
On the positive side, if the US and its allies can effectively suppress Iran’s missile and UAV capabilities soon, the narrative of rising inflation and interest rates could diminish, thereby strengthening the euro’s position. However, there is currently no substantial evidence that Iran will cease its attacks, even in the face of a massive, continuous airstrike campaign. The mountainous terrain and vast land expanses of Iran may render air military action insufficient. This scenario may not become a reality for several weeks, making more room for the euro to decline.
If the war lasts for a long time, we will observe how oil and gas markets return to equilibrium. Higher prices encourage producers to increase their supply in the market, which in turn pushes prices lower. This adjustment could help the euro recover.
The forward curves for TTF natural gas and crude oil futures support this outlook, as front-month contracts maintain a significant premium over deferred expiries.
The worst-case scenario involves causing severe damage to oil and gas infrastructure in the region, disrupting supply for an extended period. In this situation, energy prices could remain elevated for months, exacerbating the crisis in the eurozone and causing the euro to plunge, potentially reaching parity with the dollar or falling below it.
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