Is Euro Strength the New Headwind of 2013?
The recent strength in the European single currency has fueled concerns of further pain for the struggling euro zone, prompting French President Francois Hollande to call for reforms to the international monetary system.
(Read More: France's Hollande Calls for Stable Euro Policy)
Since the European Central Bank (ECB) President Mario Draghi promised to do "whatever it takes" to save the euro in July last year, investor sentiment for the single currency has surged.
The euro closed roughly 2 percent higher at the end of 2012, and has been one of the strongest performing currencies this year. Year-to-date the euro has gained nearly 3 percent against the dollar, 12 percent against the yen, 3.3 percent against the Australian dollar and 6.8 percent against the pound sterling.
However, industry participants are now fretting over whether too strong a currency could derail Europe's recovery by dampening export demand.
Markit's Purchasing Managers' Index (PMI) for the euro zone rose to a 10-month high of 48.6 in January, up from 47.2 in December, suggesting signs of a recovery. However, France's PMI slipped to a four-year low.
(Read More: Euro Zone Showing Signs of Recovery, Optimism Builds)
Currency analysts said the rally has further steam in it and could ramp up pressure on struggling euro zone nations including France, Spain, Italy and Greece.
Jesper Bargmann, head of G11 spot foreign exchange for Asia-Pacific at RBS Global Banking and Markets, sees the euro rallying another 5-10 percent by the year-end.
"The fear has gone and has moved to caution. People are moving out of safe haven currencies and Asian-yielding currencies and back into the euro," he said. "Nothing is needed to spur the euro on as this is a strong trend."
"However, factors that could derail it include anything that hurts global risk appetite, such as the resurgence of trouble in the European peripherals for example," he added.
Bargmann added that the recent strength of the euro is a real concern for European economies, especially as policymakers have limited power to control the single currency.
On Tuesday, French President Francois Hollande said that the continued strength of the euro risks deepening the recession in the euro zone, which contracted 0.1 percent in the third quarter of 2012.
He called upon European policymakers to establish an exchange rate policy to prevent the euro fluctuating with the mood of the markets. His call was quickly rebuked by German officials however, who have made their opposition to exchange rate intervention abundantly clear in recent years.
"There is talk of a global currency war, but Europe cannot really participate, because of the way decisions are made. The ECB (European Central Bank) is in the process of shrinking its balance sheet, while Japan and the U.S. are expanding. This disparity in monetary policy is reflected in the current euro/yen trade," said Bargmann.
(Read More: Why Currency Wars Might be Coming)
However, Sean Callow, senior currency strategist at Sydney-based Westpac Bank, said the French President should be thankful the euro has not rallied further.
"The euro is not that strong. In my opinion Hollande is complaining too early," Callow said. "Speculators have only just turned slightly bullish on Europe in the past month or so and have been short the euro since August 2011. It could have been a much larger move."
"If he (Hollande) wants a weaker currency, I suggest he creates another crisis, or there needs to be an expulsion of a member of the euro zone," added Callow.
According to Callow, the euro will run to 1.38 against the dollar over the next month, before falling back to 1.29 by the end of the year. The basis for this correction will be more bad news coming out of Europe, combined with better news from the U.S.
(Read More: Euro Rises Across the Board on Positive Data)
"Our growth forecast is below consensus expectations. We see the euro zone contracting by 0.4 percent in 2013. We expect another round of Greek funding and the resurgence of Spain asking for another bail-out," Callow said.
The International Monetary Fund (IMF) has forecast the 17-country euro zone will contract by 0.2 percent in 2013. Meanwhile, the ECB predicts a 0.3 percent contraction in 2013 - a marked reduction on its forecast three months ago that the euro zone would grow 0.5 percent this year.
- By CNBC's Katie Holliday; Follow her on Twitter: @HollidayKatie