Why the euro bears will eventually win

Although the euro has remained strong against the US dollar, the pressure on the single currency looks set to become overwhelming.

This week's data revealed that April headline inflation in the euro zone came in lower than expected at just 0.7 percent. Such anemic inflation numbers may encourage the European Central Bank to ease its monetary policy further even as the U.S. Federal Reserve continues to taper.

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But more importantly, investors in the euro zone are pricing in almost none of the existential threats that plagued the 18-country bloc just a few years ago -- even though many of its fundamental problems have not been resolved. These risks alone warrant a much bigger discount in the euro-U.S. dollar exchange rate than we're currently seeing.

Euro zone risk assets continue to benefit from huge investor demand. Spanish and Italian equities continued to outperform wider euro zone equities over the past month. Spanish five-year yields now trade within U.S. five-year Treasury yields.

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And, on a rating-adjusted basis, European Union high-yield spreads are lower than U.S. high-yield spreads for the first time since May 2008. The average "yield-to-worst" in euro high-yield bonds, or the lowest yield an investor can receive without an issuer defaulting, is now just 3.5 percent, a fall of roughly 0.75 percentage points since the start of the year and the lowest level ever.

Perhaps most startling, Greece was able to come back to the public debt markets just two years after experiencing the largest sovereign debt restructuring in history, despite its astronomical amounts of debt in relation to the size of its economy, which is expected to rise to 177 percent this year.

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The vast balance of its existing debt is now held by governments and governmental agencies that cannot or will not take a nominal writedown. If things go wrong, the "lucky" investors who received an allocation in the recent issue, which was seven times oversubscribed, will be left holding the only Greek paper that can still be written down. In effect, Greece, the weakest credit prospect in the euro zone periphery, was able to sell bonds that amount to little more than preferred shares at yields of less than 5 percent for five years.

The reasoning behind this ubiquitous love for all things euro zone is held to be economic improvement and the prediction that corporate earnings will bounce back. The longer-term selling point for European risk assets, however, is investors' belief that ECB President Mario Draghi will do "whatever it takes" to hold the region together.

Nevertheless, looking over the medium term, the euro zone's cracks have been papered over rather than filled. Arguably nothing has fundamentally changed since the depths of the euro zone sovereign debt crisis in 2011. The region's economy has improved, but has only moved from terrible to feeble.

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The ECB has stuck to its euro-saving acronym, the OMT. Yet the Outright Monetary Transactions have scarcely been implemented. Voter dissent continues to rise, with polls for the upcoming European parliamentary election showing increasing support for euroskeptic parties.

And the core existential issue facing the euro zone remains. Monetary union without fiscal union is not sustainable, yet fiscal union remains unpalatable for Germany.

So the euro will come under continuing pressure, not only from near-term dovishness by the ECB, but from the medium-term risks that are built into the euro zone's monetary union. In particular, U.S. dollar bulls look set to gain ground.

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Bad weather earlier in the year softened the U.S. dollar. But as the U.S. labor and housing markets improve and the Fed keeps tapering, we expect the world's premier reserve currency to announce its ascent.

Although the euro trades at 1.39 to the dollar today, we forecast it will trade closer to 1.24 in 12 months' time. It might be prudent for euro bulls to shut up shop now rather than wait for ECB easing – or discontent about the single currency – to derail them.

Simon Smiles is chief investment officer for ultra-high net worth at UBS Wealth Management.