Europe Economy

Is the Euro Set for a Big Summer Selloff?

With persistent uncertainty over the coherence of the Greek government's policies and over European policymakers' ability to agree on a fresh bailout package for the country, the euro should be on shaky ground, and some market observers said it could be set for a big fall.

However, the single currency remains strong against the dollar and the sterling , well above its fair value, according to UBS currency strategist Mansoor Mohi-uddin.

The main drivers of the euro's apparent strength, Mohi-uddin told, are in the US, as the Federal Reserve's ongoing program of quantitative easing – under which is pumps liquidity in the markets buying Treasurys - weighs on the dollar. 

"The euro tends to trade favorably when investors are risk-seeking. It gets drawn out of the low-yielding economies like the US, Japan and in some cases Switzerland, and it goes into the high-yielding euro zone," Mohi-uddin said.

The strength of the Swiss franc against the euro shows that investors are still hedging against concerns in the single currency area to some extent, he added.

With the European Central Bank currently the only major central bank raising interest rates, the differential between the US and Europe is growing. Add to this the uncertainty over the US Congress' debates on raising the debt ceiling and slightly soft data in North America, and the conditions have been ripe for artificially inflating the euro, analysts said.

"My big worry is that when the Fed ends quantitative easing it will challenge the environment for risk assets because the Fed won't be providing that additional liquidity anymore to financial markets, it will be harder for commodities, other risk assets, to rally, so we think the money will come out of the euro and go back into the safe haven currencies," Mohi-Uddin said.

"The markets seem to think that the US will continue with very loose monetary policy, and possibly have a third round," he said.

ECB Can't Be That Hawkish

"Investors seem to think that the other central banks – the ECB, maybe the Bank of England, the RBA in Australia - will keep on raising interest rates, but what we're seeing actually is that slowly investors are realizing that the ECB can't be that hawkish to keep on raising its rates aggressively in this environment where global growth is slowing and the euro zone peripheral countries are struggling," Mohi-Uddin explained.

"We're worried that the market has priced in too many rate increases on the European side," he added.

This is all pointing to a selloff in July, once issues in the US begin to be resolved, and markets again start to focus on the euro zone's crisis.

Morgan McDonnell, head of FX at RBC, concurs.

"I don't think we'll see the absolute tank that people are calling for, but I definitely see it slipping," he told

The fall will be moderated by a stronger medium-to long-term outlook for the euro, which may emerge from the sovereign debt crisis with a stronger, if narrower set of underpinning economies, McDonnell said.

While no clear mechanism exists for a country to exit the single currency, many observers have floated the possibility of Greece abandoning the euro to free up its monetary policy.

This would inevitably create further problems, as the country's debt would remain denominated in euros, and devaluation of the new drachma would increase the burden of repayment.

However, cutting the weaker peripheral economies from the single currency would strengthen it in the long term, McDonnell believes.

In previous conversations about what will happen with the euro, "people assumed that the euro would just be dumped," he said.

"There's definitely a strong school of thought that's saying, well, no, because whatever the euro is like when this is over, it may only be made up of five or six currencies, but they will be much stronger, more coordinated economies than the peripheral economies are at the moment," he said.