Europe's next challenge: A strong euro

January 30, 2013: 12:30 PM ET
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NEW YORK (CNNMoney)

The euro rallied to a 13-month high Wednesday, as fears of a financial meltdown in Europe continue to abate, thanks in large part to the European Central Bank.

Last year, ECB president Mario Draghi pledged to do whatever it takes to preserve the currency.

More recently, the ECB said that European banks had repaid €137 billion worth of emergency loans, raising hopes the financial sector is on the mend.

"The last euro bear seems to have died on Friday," analysts at Nomura proclaimed in a research note, saying the currency market is showing signs of "EURphoria."

The euro is now firmly above $1.35, topping a key technical level that analysts say could pave the way to $1.40.

That's a far cry from where it was at the height of Europe's debt crisis last July, when it fetched about $1.20.

In another bullish sign, investors increased long bets on the euro by $2.3 billion last week, according to data from the Commodities Futures Trading Commission.

Of course, the euro area still faces a host of economic and political challenges. The eurozone economy slipped back into recession last year and economists expect growth to remain weak in 2013.

"It is hard to see a strong case for a sustained euro rally, as the eurozone continues to suffer from a severe growth shortage," said the Nomura analysts.

Related: Spain sinks deeper into recession

The euro's strength comes at a time when other central banks are moving toward policies that effectively weaken their currencies.

The concern is that a stronger euro will make European exports more expensive on the global market, potentially a major setback for euro area economies struggling to regain competitiveness.

Germany, the region's export powerhouse, has been particularly concerned.

Chancellor Angela Merkel and other top German officials have expressed concern about recent moves by the Bank of Japan, which many critics say is deliberately trying to weaken the yen.

The rhetoric from Berlin raised fears about a currency war, but the ECB is expected to stay on the sidelines.

Austerity forcing Europe recession - Soros

"The Europeans are neutral," said Tommy Malloy, chief analyst at FX Solutions. "They're not in a position to dictate anything in terms of the direction of the currency."

While eurozone officials would probably welcome a weaker currency, they are unlikely to do anything that would undermine the improved sentiment toward the euro, he added.

"The short-term currency strength may be the bitter pill they have to take in exchange for improved sentiment," said Malloy.

Related: Europe on the mend, but eurozone still shaky - Draghi

Others believe a currency war is already underway, and that Europe is wise for sitting it out.

"We have been in a currency war since 2010," said James Rickards, senior managing director at Tangent Capital Partners and author of Currency Wars: The Making of the Next Global Crisis. "Right now, we are in a period where the fighting is more visible."

Rickards argues that the Federal Reserve has been deliberately undermining the U.S. dollar by cutting interest rates to zero and expanding its balance sheet.

The Fed's goal is not just to double U.S. exports, as President Obama has said, but to "import inflation" by increasing import prices, he said. This strategy is politically expedient, but it will not lead to sustained economic growth, according to Rickards.

"Europe is doing everything right," he said. "You don't promote exports with a cheap currency, you promote exports with good products."

Tom Cooley, economics professor at the NYU Stern School of Business, said the latest monetary policy moves do not constitute a currency war, although he acknowledged that there can be unintended consequences for exchange rates.

"This is a period in which economies are focused on their own recoveries," he said. "If there are spillover effects, it's not a war, it's more collateral damage."

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