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Why Odds Are Stacked Against Strong Euro

Sha Ying | CNBC

The euro has gained more than 4 percent against the U.S. dollar since mid-May, but forex analysts tell CNBC that the single currency is headed lower.

After hitting a four-month high of $1.339 on Thursday, the euro is expected to retreat back to $1.25 by the year-end - levels unseen since September 2012 - according to experts.

Michael Woolfolk, senior currency strategist at the Bank of New York Mellon, said downside risks to the euro remain despite its recent rise.

"Once we get beyond Angela Merkel's re-election in Germany this Fall, I think there's added volatility to the euro and downside risks," Woolfolk told CNBC Asia's "Squawk Box" on Friday, referring to Merkel's pledge last month that her election campaign will focus on defending a strong euro.

"l'd like to see not only the euro-dollar below 1.30, but I expect it to hit 1.25 before the year end," he added.

Mitul Kotecha, head of global currency strategy at Credit Agricole, backed that sentiment saying that while recent economic data out of Europe has been less negative and the European Central Bank (ECB) hasn't been aggressive on monetary easing, further upside momentum for the euro is going to fade.

"The supporting fact is that general weakness in the dollar will reverse, so we're looking for euro-dollar to slow its gains in the near-term and reverse in the medium-term," Kotecha said.

Data out of Europe last week showed that the region's economic woes eased slightly in May. The Markit's Eurozone Composite PMI (Purchasing Managers' Index), which gauges business activity across the region, rose to 47.7 from 46.9 - improving for a second month in a row despite remaining below the key 50 mark that separates growth from contraction.

(Read More: Europe's Economic Woes Ease Slightly in May, Prospects Mixed)

The ECB also kept interest rates unchanged at 0.5 percent on June 6 and President Mario Draghi said on Monday the central bank would not use its bond-buying program to save profligate countries from insolvency.

(Read More: ECB Holds Rates and Cuts Growth Forecast)

This was supportive for the euro, but Ray Attrill, co-head of currency strategy at National Australia Bank, said this did not mean that overall investor sentiment of being underweight on the euro had changed.

He added that if the upcoming U.S. Federal Reserve meeting next week does signal the start of tapering of quantitative easing in the U.S. within the next several meetings, then the U.S. dollar will recover its "poise."

"In that environment, I would think that euro would probably struggle to maintain its recent gains. We think the euro-dollar will head back down below 1.30 into the third quarter," Attrill said.

(Read More: Why the Fed Will Try to Calm Market Nerves)

The U.S. dollar index has fallen more than 3 percent since the start of June - its biggest decline in a two-week period in over a year.

Fund flows out of emerging market currencies on fears of Fed tapering, which have also benefited the euro, will also reverse, Kotecha of Credit Agricole added.

"There's definitely some funds flowing into Europe... but I think capital flows out of emerging markets aren't going to continue, so we expect some return of flows that will eventually undermine the euro," Kotecha said.

- By CNBC.com's Rajeshni Naidu-Ghelani; Follow her on Twitter @RajeshniNaidu