Why Euro Seems Headed for a Fall

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Bank of America Merrill Lynch has called it the hot winter. Others allude to the Depression-era tune "Happy Days Are Here Again." Whatever the label, Europe has seen an epic rally in the euro this year, and European stocks have had a nice run as well.

Whether the era of good feelings will last is another matter, however.

A corruption scandal is roiling Spain, and calls are mounting for the resignation of Prime Minister Mariano Rajoy. In Italy, there is growing uncertainty over the outcome of the upcoming election, with former Prime Minister Silvio Berlusconi gaining ground.

(Read more: Political Jitters Trigger European Shares Slide)

Economic reports from Germany have been strong, but the French and Germany economies appear to be diverging. And then there is the matter of the potential U.S.sequester,which could batter the U.S. economy and almost certainly affect global markets.

(Learn more: Tackling the Debt)

Germany's finance minister, Wolfgang Schaeuble, summed up the situation succinctly at a conference last Friday. "The euro crisis is not over," he said, although "we're in a much better position than we were a year ago."

The clouds on the European horizon are affecting European stocks, particularly in Spain and Italy, where key indexes have been experiencing one of their worst days in months. Madrid's IBEX index was down 1.7%, and Milan's fell 2.8%. Euro zone bank stocks were also hit hard.

As for the euro, investors seem to be getting a case of vertigo. The common currency has risen seven percent against the dollar in the last two months, and according to Kathy Lien, a managing director at BK Asset Management, "even without the calls for Spanish Prime Minister Rajoy to resign, the currency pair was due for a correction."

In addition to political risks, Lien is wary of an upcoming European Central Bank meeting and anything President Mario Draghi might say about excessive euro strength. "Traders should beware of a deeper correction in the EUR/USD this week ahead of Thursday's central bank meeting," she warned in a note to clients.

Economists at Citigroup, meanwhile, expect the tone of the European Central Bank statement to turn more cautious, and they anticipate interest rate cuts later in the year - a likely negative for the euro.

Barclays Capital is also worried about the euro in the medium to long term. Citing political uncertainties and growth prospects significantly weaker than those in the U.S., they expect the euro to drop to 1.2800 against the dollar a year from now.

At Bank of America Merrill Lynch, where strategists coined the term "hot winter," concerns about the euro abound. "Statements by Eurozone authorities that the euro is too strong reflect concerns that unfair competition could affect the recovery prospects," BofA Merrill Lynch strategists wrote to clients. "Markets seem complacent about the challenges in the periphery's adjustment. And we still believe markets underestimate the negative impact on US growth and global risk appetite of the US fiscal tightening this year."

If these experts are correct, the rest of the European winter is likely to be a chilly one.

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