Since the latest Middle East conflict erupted, large-scale global deleveraging has triggered a sell-off in risk assets. It is entirely understandable why the European Central Bank might feel a sense of unease, as this shock has hit the eurozone's exchange rate and interest rate markets particularly hard.

While safe-haven capital inflows have driven broad-based strength in the US dollar, the euro has fallen more than any other major currency, even twice as much as the British pound. Expectations in futures markets have also shifted rapidly, moving from anticipating no monetary policy action this year to predicting policy tightening as early as July. Policymakers must proceed with extra caution.

Just weeks ago, the euro had broken above the key level of 1.20 US dollars, which had set off alarm bells in Frankfurt. This week, however, the euro has dropped sharply, approaching 1.15 dollars. Such sudden and sharp volatility often makes central bank officials nervous.

With oil prices hovering near 100 dollars per barrel, Europe is highly exposed to rising energy costs. Memories remain fresh of the surge in energy costs after the Russia-Ukraine conflict in 2022, which drove consumer prices significantly higher.

Interest rate expectations have undergone a sharp repricing. European Central Bank policymakers must balance their desire to control inflation expectations with the need to support an economy that remains weak.

Allowing markets to form expectations that it will respond with interest rate hikes could shift policy focus away from priorities. Futures markets shifted within just a few days from slightly betting on rate cuts to anticipating tightening by mid-year.

Joachim Nagel, President of the Bundesbank, stated that the ECB is "highly vigilant" regarding inflation risks. He emphasized that at the Governing Council meeting on March 19th, "we will decide whether action is needed." Such statements are not particularly helpful. Analysts believe ECB President Christine Lagarde should aim to calm market sentiment, which has become anxious.

Analysts are highly skeptical that the eurozone economy can withstand a single rate hike, let alone a series of consecutive hikes. Therefore, tighter policy could ultimately end up hurting the euro. The ECB forecasts economic growth of 1.2% this year, but this prediction relies on improved domestic consumption, rising household incomes, and better financing conditions.

The market is uncertain whether an oil price shock is compatible with this outlook. The inflation situation is somewhat complex: consumer prices rose 1% year-on-year in February, only half the ECB's target. However, core inflation increased from 2.2% to 2.4%, exceeding expectations and highlighting the region's sensitivity to external price pressures.

Rising demand for the US dollar and the energy shock are key factors. Without this sharp repricing of interest rate expectations, the euro might be even weaker. A broader issue, however, is that the euro has still not become the safe-haven investment its policymakers hoped for. Analysts at Societe Generale noted:

"Despite declines in both US Treasuries and stocks, investors in this environment are still willing to hold US dollars, especially relative to the euro."

Rising prices for dollar-denominated commodities are also increasing demand for the dollar. George Saravelos, Global Head of FX Research at Deutsche Bank, stated: "A negative supply shock is occurring, which effectively acts as a direct tax Europeans must pay in US dollars to overseas producers."

He estimates that for every 10% increase in Brent crude prices, the euro currently depreciates by approximately 0.8% against the US dollar.

Demand for US dollars in cross-currency swap markets has risen significantly relative to other global currencies, reflecting increased need for dollar liquidity funding outside the United States.

The euro-US dollar basis swap spread has widened to its largest level since the implementation of tariffs on April 2nd. Similar conditions are seen in cross-currency bases for the pound and Swiss franc. While dollar funding pressure isn't extreme, the market mood is reminiscent of the 1970s energy crises, as rising bond yields reflect insufficient investor demand for duration risk.

Consequently, although markets are not in panic mode, risk premiums are rising.

Given Europe's proximity to the conflict, it is logical that local investors are more sensitive to reducing their exposure. If the conflict expands, the impact of higher inflation and impaired growth would be more severe for Europe.

In contrast, the situation for US investment assets is largely the opposite; US markets are more likely to benefit if the situation de-escalates quickly. Notably, intraday rebounds during US market hours have been stronger this month.

Central banks can manage stable exchange rate fluctuations, but sharp adjustments push them outside their comfort zone. Actual intervention often brings unintended consequences, and threatening rhetoric about potential action is usually ineffective—something the Swiss National Bank may have realized.

After failing to talk down its currency last week, market speculation suggests the SNB is intervening to limit the Swiss franc's rise against the euro to its strongest level since 2015.

The lack of a domestic energy base remains a major vulnerability for Europe—leaving it a price-taker in energy markets. This also makes it more difficult for its manufacturing sector to cope with strict net-zero emission requirements. Increased exchange rate volatility undoubtedly complicates corporate planning, but the disruption from higher interest rate expectations is far more significant.

Europe urgently needs a swift end to the Iran conflict, as the Russia-Ukraine war shows no signs of resolution. A weaker euro might be the most visible signal of pressure, but it also reflects deeper structural problems. Allowing pressure for rate hikes to build will not solve these issues.