Euro Near Year-to-Date Low Against the Dollar: Squeezed by Energy Shock and European Political Risks, Down About 2% This Month

The euro is trading not far from its lowest level of the year against the dollar, caught between a global energy shock and rising political risks in Europe. In August, the euro came close to 1.20 against the dollar, but it has fallen about 2% this month to a two-month low just below 1.14. The euro was last trading at about 1.137. A Federal Reserve rate hike has restored its inflation-fighting credibility, boosting the dollar, while the euro's outlook has been clouded by political factors and another rise in oil prices, which could hurt an economy that had been performing better than expected. "How long can this growth resilience last? Can it really make it through the whole winter? Then we go into spring, and we may run into some tricky political situations," said Jane Foley, senior FX strategist at Rabobank. German Chancellor Friedrich Merz is reeling from the far right's gains in recent state elections, an unexpected result that could force him to water down his previously promised reform agenda, while French markets are under pressure from high-debt concerns and political gridlock ahead of the 2027 presidential election. "In this environment, I am a little concerned about the euro," Foley said, adding that she is reassessing her forecast for EUR/USD at 1.16 in three months. The premium investors demand to hold French 10-year government bonds over AAA-rated German bunds has risen above 110 basis points, a warning signal for the euro. Bank of America FX strategists estimate that for every additional 10 basis points of spread widening, EUR/USD falls by 0.4%. Options traders are also becoming more negative on the euro. The three-month euro risk reversal which reflects the difference between the price of buying options on the currency and the price of selling them last week recorded its largest weekly drop since the outbreak of the Iran war. European gas prices need to fall back Analysts and investors say euro bulls still have reasons not to be discouraged, because traders are currently pricing in at least one more ECB rate hike this year and the economy has also shown resilience. But few deny that high energy prices have clouded the currency's near-term outlook. EUR/USD rose about 13% last year, but the Iran war has hurt the euro this year. The conflict has disrupted LNG shipments through the Strait of Hormuz, pushing gas prices above 80 per megawatt-hour this month, the highest since late 2022. Analysts say European gas prices need to soften for the euro to resume its rally, but that is unlikely in the near term. "If you look at the forecasts from commodity forecasting agencies, most predict European gas prices in the 85 to 100 range," said Kaspar Hense, senior portfolio manager at RBC BlueBay Asset Management. "If that happens, then the euro (against the dollar) could easily fall to 1.12," Hense added. Meanwhile, discussions about a possible U.S. ban on diesel exports would exacerbate the problems facing the euro, although analysts say this is not their base case. Francesco Pesole, FX strategist at ING, said a jump in oil prices toward $115 a barrel would add pressure, because such a level would intensify concerns about economic growth. "But if central banks maintain a hawkish stance, the euro should not depreciate significantly," he said, adding that ING is maintaining its forecast of 1.16 for EUR/USD by year-end.