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Watch Out, Euro May Be About to Flex Its Muscle

David Gould | Photographer's Choice RF | Getty Images

An expectation for the euro to head lower against a broadly-robust U.S. dollar could be turned on its head if economic data from the recession-hit euro zone continue to surprise on the positive side, currency strategists say.

The euro rose about half-a-percent on Monday after data showed that manufacturing output in the euro zone improved in June to a 16-month high in a sign that the euro zone economy was stabilizing.

(Read More: Euro Zone June Manufacturing PMI Rises to 16-Month High of 48.8)

It was trading at about $1.3060 on Tuesday, moving away from a three-week low hit last week just below $1.29.

"There have been some better numbers so there's some hope on the growth side," said Sean Callow, senior currency strategist at Westpac Bank, in Sydney.

"There is some degree of optimism there and that is worth keeping an eye on, especially if you are short the euro," he said referring to bets on euro weakness.

Monday's Purchasing Managers' Index (PMI) data from Spain and Italy in particular drew attention, with the Italian PMI rising to its highest level since July 2011 and the Spanish number rising to 50 in June from 48.1 in May and hitting the key barrier that divides expansion in manufacturing activity from contraction.

Further Gains?

Ed Ponsi, managing director at Barchetta Capital Management told CNBC Asia's "Squawk Box" that a combination of upbeat data from the euro zone, strong chart support at $1.30 and expectations for a pull-back in the dollar against major currencies pointed to further gains in the euro.

"The euro has caught a bid and $1.30 has been a huge level of support for the euro, not just this past week but earlier this year and late last year also. So I think we will see $1.32 on the euro before much longer," he said.

"The dollar index is due a little bit of a pull-back. One of the main beneficiaries of that is likely to be the euro and we've had some great numbers on Monday; the Spain and Italy PMIs are very good and getting back to 50. This is very important, I think Europe is starting to come around," he added.

(Read More: Euro Zone Industrial Output Shows Surprise Rise in April)

Growing optimism towards the euro zone is in sharp contrast to a year ago, when fears about financial woes in Spain prompted investors to pile out of euro zone assets and dump the euro.

On Monday, the better-than-expected PMI data from Spain and Italy helped European shares start the third quarter of the year on a strong note, while yields on Italian and Spanish bonds fell.

"It is worth keeping an eye on Spain and Italy, where there were sharp rallies in stocks and bonds overnight," said Westpac's Callow.

Other analysts said that while they maintained forecasts for the euro to head lower against a robust dollar, the euro should hold its ground relatively well amid signs that the worst may be over for the euro area's weakest members.

(Read More: Spain Will Bottom Out This Quarter: Santander Exec)

"We forecast $1.29, $1.27 for the euro on the assumption that U.S. data will be better and there will be a tapering of QE [quantitative easing]," said Thomas Harr, head of Asia local markets strategy at Standard Chartered Bank.

"But we won't see the $1.20 levels again because the European situation is more stable than a year ago," he said referring to levels the euro fell to amid worries about the euro debt crisis.

- By CNBC's Dhara Ranasinghe; Follow her on Twitter: @DharaCNBC