Euro hit by energy shock as Iran war exposes vulnerability - but recovery hopes remain

The euro was one of the main underperformers in the G10 following the outbreak of the Iran war, as markets ditched currencies of heavy oil importing nations.

Unlike the US, the Euro Area economy appears relatively exposed to the conflict given its reliance on energy imports and the spike in EU natural gas prices. A weaker euro should act as a partial shock absorber, as this both boosts competitiveness of European exporters and inflates the value of repatriated foreign earnings. However, since oil is priced in dollars, a weaker euro also amplifies the inflationary impact of any sustained oil price surge. This leaves the ECB in a tough spot, as it's caught between supporting growth on the one hand and keeping inflation in check on the other.

The outlook for the euro is far from devoid of optimism, however, and we still favour upside in the EUR/USD pair over our forecast horizon, particularly should we see a reasonably timely resolution to the conflict. Growth should be supported by Germany’s massive €500 billion infrastructure bazooka and the delayed impact of the ECB’s aggressive easing cycle. Relative political stability and predictability mean that European currencies are likely to remain the default alternative destination for investors amid US policy uncertainty.