The ongoing crisis in the Middle East has highlighted vulnerabilities in the dollar’s value. Anticipated spikes in geopolitical risk and oil prices typically support the dollar’s strength, but recent reactions have been muted and temporary.
The foreign exchange market, known for its efficiency, is not fully pricing in the risks of a prolonged conflict or sustained higher energy prices. This hesitance stems from broader concerns about the dollar’s medium-term outlook.
The limited response to supportive news and the swift return to lower levels once tensions ease illustrate the ongoing relevance of these concerns. As for the short-term outlook for EUR/USD, our model indicates a significant increase in fair value, which recently climbed from just below 1.10 to around 1.145.
This shift is largely attributed to a 20 basis point tightening in the EUR:USD swap rate gap favoring the euro. Factors contributing to this include a more dovish Federal Open Market Committee (FOMC) and a hawkish European Central Bank (ECB).
At the current level of 1.170, the EUR/USD risk premium stands at approximately 2.5%, halved from earlier weeks. If the market retracts the USD risk premium to previous levels, EUR/USD could approach 1.20.
Several conditions could trigger a bearish shift for the dollar. Key risks stem from tariffs and the U.S. deficit, especially as discussions heat up regarding fiscal measures in Congress.
Additionally, reports about President Trump’s potential intervention in the Federal Reserve’s leadership are adding to uncertainty around the dollar. There is increasing anecdotal evidence of institutions hedging their dollar-denominated assets, possibly seeking alternatives due to current policies.
If fears surrounding Powell’s leadership or tariffs do not exacerbate the dollar’s risk premium, traditional market drivers could bring EUR/USD toward 1.20. Our current perspective, since the last update, remains cautiously optimistic regarding EUR/USD.
While diminishing geopolitical risks and FOMC divisions have created bullish sentiment, excessive enthusiasm for imminent Fed cuts may not be warranted. We believe EUR/USD may stabilize around 1.15-1.16 as it awaits clearer inflation signals.
Significant movement toward 1.20 will require either pronounced dollar risk—through tariffs, the deficit, or Fed independence concerns—or a more dovish Federal Reserve. While these remain relevant risks, they are not currently central to our baseline scenario.