The euro is trading lower against the US dollar during Friday's Asian session, slipping from its June 18 high of around 1.1530 to current levels near 1.1510, as the expanding US-Iran conflict triggers risk aversion in the market. The Iranian parliament speaker has stated that the US will "pay the price for killing Iranian civilians," while Saudi Arabia and 13 other countries have announced the formation of an international coalition to ensure freedom of navigation in the Red Sea and the Gulf of Aden. The widening scope of geopolitical tensions is putting downward pressure on the euro, a risk-sensitive currency.
However, the Federal Reserve's decision to hold steady and Chairman Walsh's refusal to provide clues on future policy adjustments, combined with the European Central Bank's clear guidance for a September rate hike, are offering a floor of support for the euro.
The euro's immediate weakness is directly tied to the escalation of Middle East geopolitical risks. The Iranian parliament speaker's statement that the US will "pay the price" hints at the possibility of further retaliatory actions from Tehran. Concurrently, the formation of a coalition by Saudi Arabia and 13 other nations to safeguard navigation in the Bab el-Mandeb strait, the Red Sea, and the Gulf of Aden reflects serious regional concerns over threats to shipping security. The expanding conflict is fueling risk aversion, which is pressuring the euro and other riskier currencies.
The Fed's inaction and Walsh's lack of forward guidance are raising questions about its commitment to fighting inflation. The Fed left interest rates unchanged on Wednesday, but Chairman Walsh explicitly declined to provide clues on future policy adjustments during the press conference. This has sparked market doubts about whether the new chair is "serious about curbing inflation." This uncertainty is weakening the US dollar and providing a boost to the euro. Data from the CME FedWatch Tool shows that market pricing for a September rate cut has fallen from about 77% before the meeting to 63.4%, reflecting growing uncertainty about the Fed's policy path.
The ECB's clear guidance is offering the euro a "comparative advantage." Strategists at DBS Bank note that the euro is drawing support from Europe's clearer policy direction compared to the US. They state, "While Walsh leaves the US market fumbling in the dark, the ECB is more unified in signaling a September rate hike," adding that this stance "is giving the euro a distinct comparative advantage over the dollar." The clear expectation of an ECB rate hike in September provides a solid floor for the euro, even as geopolitical risks weigh in the short term.
The euro is currently at a crossroads, influenced by several key variables. Further escalation in the Middle East would heighten global risk aversion, significantly pressuring the euro as a risk-sensitive currency. An expanded conflict could disrupt energy supplies and trade routes, increasing uncertainty for the European economic outlook. Investors would likely sell euro-denominated assets and move towards safe-haven currencies like the US dollar, creating sustained downward pressure on the euro.
Eurozone HICP data is also a critical factor. A stronger-than-expected inflation reading would reinforce market expectations for the ECB to maintain or accelerate its rate hike path. Sticky inflation would limit the scope for policy easing, supporting the euro's interest rate advantage and attracting capital flows, thereby partially offsetting the negative impact of geopolitical risks and providing temporary support for the euro.
Fed policy expectations represent another important variable. If the market continues to price in a lower probability of a September rate cut, the US dollar would face significant headwinds. Earlier expectations for rate cuts or a reduced probability of hikes would weaken the dollar's interest rate advantage, prompting capital to flow to other currencies, including the euro. In this context, the euro's direction will be determined by the dynamic interplay between Middle East risks, European inflation data, and Fed expectations.
The euro is finding a balance between geopolitical risks and ECB guidance. The EUR/USD pair has retreated from recent highs to around 1.1510 against the backdrop of the expanding US-Iran conflict. Rising geopolitical tensions are pressuring the risk-sensitive currency, but the ECB's clear guidance for a September rate hike is providing a floor. The Fed's inaction and Walsh's lack of forward guidance are weakening the dollar, while the ECB's relatively unified hawkish stance is giving the euro a "comparative advantage." In the short term, the pair is likely to trade in a range between 1.1480 and 1.1570. A further deterioration in the Middle East situation could see the euro test support at 1.1480. Conversely, if geopolitical risks cool and expectations for an ECB rate hike strengthen, the euro could break above resistance at 1.1570 and move towards the 1.1600 level. The medium-term direction of the euro will depend on the relative strength of the ECB and Fed policy paths.
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