The euro’s strong run against the dollar is facing a new test as higher energy prices, political uncertainty and renewed pressure on European bond markets threaten to undermine a currency that had appeared increasingly resilient.
The euro had been heading toward $1.20 in August, but has since fallen about 2% this month to around $1.14, bringing the currency close to its weakest levels of the year.
The retreat comes as a stronger dollar gains support from expectations around US monetary policy, while investors reassess whether Europe’s economy can continue to withstand another energy shock.
The Euro’s Rally Is Running Into a New Wall
The euro’s rise had been supported by signs that the European economy was performing better than expected and by expectations that the European Central Bank could raise interest rates again this year.
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But the renewed increase in energy prices has complicated that picture.
“How long can this growth resilience last?” asked Jane Foley, senior currency strategist at Rabobank. She said investors would need to consider whether European growth could remain resilient through the winter, particularly with political uncertainty potentially becoming more disruptive in the spring.
The euro’s decline has also been reflected in options markets. Three month risk reversals, which measure the relative demand for options betting on a currency’s rise or fall, recorded their biggest weekly decline since the beginning of the Iran war.
Europe’s Political Risks Are Starting to Hit Markets
Germany and France are adding another layer of uncertainty to the euro’s outlook.
German Chancellor Friedrich Merz is facing pressure after the far right performed strongly in recent state elections, potentially making it harder for his government to pursue the reform agenda it has promised.
In France, concerns about high public debt and political gridlock are weighing on markets ahead of the 2027 presidential election.
Those political pressures are increasingly visible in government bond markets. The premium investors demand to hold French 10 year government bonds over highly rated German debt has climbed above 110 basis points.
According to Bank of America currency strategists, every additional 10 basis point widening in that spread could be associated with a 0.4% decline in the euro against the dollar.
Europe’s Energy Problem Is Back
The biggest immediate challenge for the euro, however, may be energy.
The conflict in the Middle East has disrupted liquefied natural gas shipments through the Strait of Hormuz, pushing European gas prices above €80 per megawatt hour this month, their highest level since late 2022.
That matters because higher energy costs can squeeze households and businesses while increasing inflationary pressure, making it harder for Europe’s economy to maintain its recent resilience.
Analysts say European gas prices would need to fall for the euro to regain momentum, but a rapid decline is not expected.
Kaspar Hense, senior portfolio manager at RBC BlueBay Asset Management, said commodity forecasters were generally expecting European gas prices to remain around €85 to €100 per megawatt hour.
At those levels, Hense said, the euro could fall toward $1.12.
Oil Prices Could Add Another Layer of Pressure
The outlook could deteriorate further if oil prices rise sharply.
ING currency strategist Francesco Pesole said a move toward $115 a barrel would increase pressure on the euro by intensifying concerns about European economic growth.
A possible US ban on diesel exports could also create additional difficulties for European energy markets, although analysts do not currently regard such a measure as their main scenario.
The combination of higher oil and gas prices creates a difficult environment for the euro. Europe is highly exposed to imported energy, meaning a prolonged increase in prices could weaken growth while simultaneously keeping inflation elevated.
The Euro Still Has Reasons to Hold Its Ground
Despite the growing risks, the euro’s outlook is not uniformly negative.
Traders are pricing in at least one more euro zone rate hike this year, while recent economic data have continued to show greater resilience than many had expected.
That could provide some support for the currency if the European Central Bank maintains a relatively hawkish stance.
“If central banks stay hawkish there should not be a sharp depreciation of the euro,” Pesole said, with ING maintaining its year end forecast of $1.16 for the euro against the dollar.
Rabobank’s Foley, however, said her previous three month forecast of $1.16 was under review.
The euro therefore enters the final stretch of the year facing a very different set of conditions from those that powered its earlier rally. Its ability to regain ground against the dollar may depend on whether Europe can absorb the energy shock without losing its economic resilience, while governments in Berlin and Paris navigate increasingly difficult political and fiscal pressures.
