A Spanish bailout could give the euro a short-term boost, but the currency remains highly vulnerable to developments in the euro zone and prospects for European banks in particular, analysts said on Tuesday.
The euro strengthened significantly against the U.S. dollar between July 26, when European Central Bank President Mario Draghi said he would do "whatever it takes" to keep the euro zone intact, and the resumption of quantitative easing by the Federal Reserve announced on Sept. 14. It remains 7 percent higher than its July trough, Barclays analysts said.
Paul Robinson, head of foreign-exchange research at Barclays, said in a research note that the biggest risk to the strength of the euro was a “remaining euro area risk,” with the banking sector “crucial” to this.
He added that one of the most important issues facing Europe over the next few years was “how to cope with the huge European banking sector as it continues to recapitalize, shrink its balance sheet, and adjust its funding model in the post-financial crisis world.”
The euro steadied Tuesday after falling to a one-week low against the dollar on Monday as concerns about the euro zone debt crisis persisted.
More muted German business sentiment added to concerns about whether Madrid will request a full Spanish bailout.
In a separate note, CitiFX said markets were braced for a Spanish request to come in time for the next European Union summit on Oct. 18, with Citi economists considering it more likely after the Spanish elections on Oct. 21. CitiFX analysts said a bailout would be a boost for the single currency, but only temporarily.
It may not be sustained if Spain’s growth remain weak and currency breakup risks persist, with the likelihood of a Greek exit from the euro zone bloc increasing. (Read More: Greece May Seek ECB Debt Rollover to Plug Funding Gap.)
CitiFX added that it expects Italy to request a bailout in the coming months too. All this uncertainty in the euro zone, the analysts argue, poses a risk for the single currency.
The Draghi bounce — improved equity market performance on the back of ECB president Mario Draghi’s unlimited bond-buying plan known as Outright Monetary Transactions for weaker euro zone countries — managed to buoy markets in the short term, helping to boost the euro as well. (Read More: ECB Is Just ‘Bridge’ Towards Stable Future: Draghi.)
But German newspaper Bild reported on Tuesday that the European Central Bank and Germany’s Bundesbank have drafted in lawyers to check the legality of the plan and whether it could be in breach any EU treaties.
Barclays' Robinson says the reduced risk to banks as a result of the Draghi plan and the U.S. Federal Reserve’s decision to release another round of quantitative easing — dubbed QE-Infinity due to the fact that the Fed has not announced a deadline and limit to the stimulus — helped to boost equities in the immediate sessions afterward, but a sustained rally has not materialized.
“The health of the banking sector is going to continue to matter enormously for European currencies, even if we are past the worst in terms of the sovereign crisis itself, and is a crucial channel by which weak growth will lead to currency weakness,” Robinson warned.
—By CNBC's Shai Ahmed; Follow Her on Twitter @shaicnbc