The Middle East conflict deals a heavy blow to Europe’s economy! The euro posts its worst single-quarter performance since 2024, with bearish sentiment reaching a four-year high.

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The Middle East conflict is driving up energy prices, reshaping the foreign exchange market landscape. The euro is on track for its worst quarterly decline since the start of 2024, as Europe’s heavy reliance on energy imports is once again exposed, 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 multi-year peak.

The euro has fallen about 2% against the dollar this quarter, currently trading near $1.15, with a 2.5% drop in March alone—the largest single-month decline since July 2024. This stands in stark contrast to the euro’s robust performance at the end of January, when it broke through $1.20, a near five-year high. The team led by Morgan Stanley strategist David Adams expects the euro to dip further to $1.13 in the near term.

Rising oil prices and disruptions at the Strait of Hormuz have prompted currency traders to revisit the playbook from the 2022 Russia-Ukraine war—when European markets were severely hit and the dollar surged. Meanwhile, the currency market has now fully priced in three ECB rate hikes this year, a dramatic shift from just a few weeks ago when there was a 35% probability of a rate cut.

Options Market Shows Rising Bearish Sentiment

Signals from the derivatives market are even more pessimistic than analysts’ forecasts. According to a Bloomberg survey, analysts’ year-end target for the euro is $1.20, but option contract implied moves are much weaker. Earlier this month, demand for downside protection on the euro reached a four-year high; previously, traders had been paying hefty premiums for bullish bets, but this preference has now dissipated, with the market mood turning neutral.

Looking at specific currency pairs, bearish bets on euro-yen options outnumber bullish ones by almost four to one; positions against the Swiss franc and Australian dollar are similarly bearish, though to a lesser extent. However, the euro is not weak against all currencies—according to DTCC data this month, traders are more than four times as likely to bet on the euro appreciating against the pound than depreciating, a sign that euro market sentiment is highly differentiated depending on the pair.

Energy Shock Puts ECB Back in a Dilemma

Soaring oil prices are putting the European Central Bank in a tricky policy dilemma. ING points out that while rate hikes usually support the currency in times of robust growth, the Middle East crisis has broken that logic—with supply bottlenecks from the Gulf region set to tighten global financial conditions by reducing overseas investment, and growth-sensitive currencies like the euro first in line to be impacted.

German inflation data shows price growth at the highest level in a year due to rising energy prices. The ECB now faces a situation much like 2022: energy-driven inflation occurring alongside slowing economic activity, leaving extremely limited policy space.

Fiscal Optimism Fades, Growth Forecasts Cut

The fiscal tailwinds that previously supported the euro are fading. Optimism over Germany’s fiscal policy shift and expanded defense spending has markedly cooled, while the OECD has simultaneously revised down its growth forecast for the eurozone, with Germany and Italy also considering lowering their official growth projections.

This means that the multiple drivers which pushed the euro to a near five-year high at the start of the year—expectations of fiscal expansion, weakness in the dollar—have been successively offset by the energy shock in just a few weeks.

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