Since the outbreak of the Iran conflict, global markets have experienced a significant deleveraging of risk assets, with the eurozone’s exchange rate and interest rate markets bearing particularly severe impacts. Against a backdrop of broad-based safe-haven buying of the U.S. dollar, which has driven up the dollar index, the euro has fallen against the dollar by a much larger margin than all other major currencies, declining twice as much as the British pound. At the same time, market expectations for European Central Bank monetary policy have undergone an extreme reversal, shifting from pricing in no policy action for the full year at the start of 2024 to betting on an interest rate hike as early as July this year.

Policy makers at the European Central Bank are advised to proceed with extreme caution, as blindly following market expectations for rate hikes could further exacerbate the eurozone’s difficulties. Just a few weeks ago, the euro touched the 1.20 level against the dollar—a threshold that typically raises alarm at the ECB. However, this week the euro has plunged sharply to around 1.15, a rapid decline that is highly likely to trigger concern at the central bank level.

Due to the high exposure of European economies to rising energy prices, with oil hovering near $100 per barrel, Europe faces a critical threat from climbing energy costs. The painful memory of soaring energy prices driving up consumer inflation following the 2022 Russia-Ukraine conflict remains fresh in the market’s mind. This situation forces ECB policy makers to balance controlling inflation expectations against the reality of a weak economy.

Market expectations have now shifted toward a rate hike—a stark reversal from just days ago, when modest rate cuts were anticipated, to now expecting monetary tightening by mid-year. If such expectations are allowed to develop unchecked, the central bank risks being pushed off course. Recent comments from the head of the German Bundesbank indicated that the ECB remains “highly vigilant” regarding inflation risks and emphasized that the March 19 Governing Council meeting “will decide whether action is needed.” However, such statements are seen as unhelpful, and it would be more appropriate for ECB President Christine Lagarde to step in to calm the turbulent markets.

There is now strong skepticism about whether the eurozone economy can withstand even a single rate hike, let alone a series of increases. Tightening monetary policy could ultimately backfire and harm the euro. The ECB previously forecast economic growth of 1.2% for this year, based on expectations of improved domestic consumption, rising household incomes, and favorable financing conditions. However, the oil price shock clearly contradicts this outlook.

The current inflation picture is mixed: consumer prices rose 1% year-on-year in February, only half of the ECB’s target, yet core inflation unexpectedly increased from 2.2% to 2.4%, highlighting the eurozone’s high sensitivity to external price pressures. Were it not for the dramatic repricing of interest rate expectations by the market, the euro might have fallen even further.

A deeper issue is that the euro has yet to become the safe-haven investment currency that policy makers had hoped for. Analysts at Société Générale noted that despite declines in both U.S. Treasuries and equities, investors remain willing to hold U.S. dollars in the current environment, especially relative to the euro. The continued rise in dollar-denominated commodity prices further reinforces structural demand for the dollar.

The global head of foreign exchange research at Deutsche Bank pointed out that the current negative supply shock acts like a direct tax that Europeans must pay in dollars to foreign producers. He estimates that a 10% rise in Brent crude oil leads to an approximate 0.8% decline in the euro-dollar exchange rate. Signals from the cross-currency swap market are also concerning: demand for U.S. dollars has surged significantly compared to other major global currencies, reflecting a notable increase in dollar liquidity funding needs outside the United States.

The euro-dollar basis swap spread has reached its highest level since the tariff shocks of early April, with similar trends observed in sterling and Swiss franc cross-currency basis. While dollar funding stress is not yet pronounced, rising bond yields and market reluctance to take on duration risk hint at echoes of the 1970s energy crisis. Thus, although outright panic has not emerged, risk premiums are climbing.

From a geopolitical perspective, Europe’s proximity to the conflict zone means local investors are naturally more sensitive to risk aversion. If the conflict escalates further, the eurozone will face significantly greater inflationary and economic downturn pressures than other economies. In contrast, U.S. assets stand to benefit more, even if the conflict subsides quickly. Notably, during intraday rebounds in global markets this month, U.S. equity sessions have shown noticeably stronger recoveries.

For central banks, moderate exchange rate fluctuations fall within normal response parameters, but sharp, one-sided adjustments often push them out of their policy comfort zones. Direct intervention in currency markets can easily trigger unintended consequences, and verbal attempts to influence exchange rates are generally ineffective—as demonstrated by the Swiss National Bank’s experience last week. After failing to talk down the Swiss franc, the market now widely suspects the SNB has intervened to prevent the franc from strengthening to its highest level against the euro since 2015.

In the long term, Europe’s lack of domestic energy supply remains a fundamental weakness, leaving it passively exposed to global energy prices with no bargaining power. Under strict net-zero emission requirements, European manufacturing already operates under significant pressure. Increased exchange rate volatility only complicates long-term corporate planning, while rising expectations for interest rate hikes pose an even more corrosive threat to the real economy.

With the Russia-Ukraine conflict showing no signs of abating, Europe urgently needs a swift resolution to the Iran conflict. While a weaker euro may be the most visible sign of market stress, it also reveals deeper structural problems. Allowing market expectations for rate hikes to continue building will not resolve the core challenges at hand.