In July 2025, the European Central Bank held interest rates steady, yet the euro sharply depreciated against the U.S. dollar, falling as much as 1.2% in a single day.
At first glance, the situation seems puzzling: the market strongly expects the Federal Reserve to cut rates in September, while the ECB is likely to keep rates unchanged, leading to a narrowing of the interest rate gap between the U.S. and Europe. Normally, a narrowing interest rate differential tends to support euro appreciation. However, this time the euro experienced an unexpected "flash crash." The root cause is not the interest rate difference itself but the agreement reached on U.S.-EU tariffs. The market widely views this as a major concession from Europe, and the tariff shock is putting substantial pressure on the Eurozone economy.
A “Reverse” Market Movement Amid Tightening U.S.-EU Interest Rate Spread
Currently, market analysts see a high chance of a Fed rate cut in September, with the ECB likely holding rates steady. As of July 28, the yield spread between U.S. and European 10-year government bonds narrowed to 1.2 percentage points, down from a peak of 1.56 points earlier this year. Historically, the euro-to-dollar exchange rate has been strongly negatively correlated with the U.S.-Europe interest rate spread. Thus, a shrinking spread should have pushed the euro higher.
Yet the opposite occurred. The recent U.S.-EU trade talks saw the EU making significant concessions. This tariff agreement disrupted the conventional interest rate-based currency expectations, accelerating capital outflows from Eurozone assets and causing a short-term decline in the euro’s value.
Eurozone Economic Structure and Growth Drivers
In the first quarter of 2025, the Eurozone’s real GDP growth (seasonally adjusted, year-on-year) accelerated slightly by 0.2 percentage points compared to the fourth quarter of 2024, reaching 1.5%, with quarter-on-quarter growth up by 0.3 points.
A notable feature this year is that fiscal expansion is the main growth driver in the Eurozone. In March 2025, Germany formally passed the "debt brake" reform law, exempting national defense spending exceeding 1% of GDP from debt limits. At the same time, the Basic Law was amended to broaden allowed investments in infrastructure, defense, and more, and a special fund of 500 billion euros was established.
However, weaknesses remain. Although growth shows cyclical improvement, consumer demand is weakening, while investment and exports are intermittent bright spots. Fundamental demand is sluggish, and structural low growth combined with external pressures continues to restrain the economic recovery base.
Wide-Ranging Impacts of the U.S.-EU Tariff Agreement
On July 27, U.S. President Donald Trump announced a uniform 15% tariff agreement with the European Union. Steel and aluminum tariffs remain unchanged, while the EU committed to increasing investments in the U.S. by $600 billion and purchasing $750 billion in U.S. energy products and military equipment. Pharmaceuticals, automobiles, and other sectors will face this new uniform 15% tariff. Tariffs on the spirits industry are still under discussion. The detailed trade agreement framework will be disclosed in the coming weeks.
Due to damage to export structures and the huge costs of investment and supply chain adjustments, the market widely fears a severe blow to the European economy. On July 28, the euro-to-dollar exchange rate suffered its largest single-day drop since May.
UBS estimates the EU’s weighted average tariff on American exports will increase from 1.5% to 15.2%. This tariff shift may reduce Eurozone economic growth projections by 0.2 to 0.4 percentage points over the next year.
Capital Flows and Changing Market Expectations
Looking back over the first three quarters of 2025, although Eurozone economic conditions improved quarter by quarter, growth relied heavily on fiscal expansion and "export grabbing." Consumer spending remained weak, and no fundamental change has addressed the structural low growth issue. The U.S.-EU tariff agreement adds pressure on Eurozone exporters, with long supply chain adjustment times worsening the situation. Combined with inherent debt structure pressures and subdued domestic demand in the Eurozone, euro assets have lost much of their appeal.
In the long term, however, the euro is unlikely to keep falling continuously. The recent dollar rebound could be temporary. When the dollar retraces from its highs and weakens again, the euro may have opportunities to recover and appreciate.
Conclusion
The main cause of the euro’s flash crash in 2025 is the recently agreed U.S.-EU tariff deal, which delivered an unexpected blow to Europe’s exports and investments. Although the narrowing U.S.-Europe interest rate spread would normally support the euro, policy and structural pressures have dominated capital flows and market expectations.
Further fiscal expansion in the Eurozone may partially ease economic shocks, but structural challenges, external pressures, and tariff policy effects ensure the euro will remain volatile and weak for an extended period.
Currency investors should closely follow U.S.-EU policy changes and proactively use foreign exchange futures for risk hedging.
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