(Reuters) - The euro is likely to stay under pressure until early next year as investors grow bearish about euro zone growth prospects and policymakers' ability to bring a rapid conclusion to the region's debt crisis.
The single currency has shed more than 3 percent against the dollar so far this week, equivalent to all its losses for 2011, as a European Union summit last week fell short of investor expectations for decisive steps to stem the bloc's debt crisis.
It hit an 11-month low of $1.2945 on Wednesday and some analysts expect it to fall towards $1.25 in the coming months, perhaps lower, as investors such as Asian central banks to Middle Eastern sovereign wealth funds express their dismay.
Speculative bets that the euro will fall remain near their highest since mid-2010.
Our current three-month euro/dollar forecast of $1.3000 is looking conservative and a move to $1.2500 is looking like a more achievable target, said Derek Halpenny, European head of global currency research at Bank of Tokyo-Mitsubishi UFJ.
That would be a far cry from this year's peak of around $1.4940 struck in early May when the ECB was still in the midst of its monetary tightening cycle to fight off inflation.
Things have changed, with the euro zone facing recession . The ECB has cut interest rates twice in two months, reversing hikes made earlier this year and cutting the euro's advantage over the dollar.
Beyond that, the risk of European banks failing due to their sovereign debt exposure along with looming threats of mass credit rating downgrades of euro zone countries and funding problems for the financial sector bode ill for the currency.
Analysts at Nomura expect this bearish sentiment to spill into 2012 with the euro hurt by a reallocation of funds away from euro zone sovereign debt and a much weaker economic outlook. They see the euro at $1.20 in the second quarter.
The euro has held up pretty well for most of 2011 despite the turmoil in peripheral euro zone debt markets and the threat of a break-up. That was mainly because of support from central bank reserve managers reallocating funds from the dollar.
Morgan Stanley estimates central banks mopped up about $500 billion this year to stop their currencies rising and investing the bulk of the proceeds into euro assets. But these flows largely stopped in September and many emerging currencies are now under pressure against the dollar.
European banks struggling to repair balance sheets have been repatriating euros and this has also supported the currency. These inflows will continue but will be outstripped by foreign funds selling euro-denominated assets, analysts said.
Bilal Hafeez, strategist at Deutsche Bank, said a similar pattern was seen in 2007-2008 when euro repatriation preceded foreign selling. Eventually foreigners' sales was the dominant driver which saw the euro lose 4.2 percent in 2008.
The euro area has a negative net international investment position like the U.S., which means that foreigners hold a larger stock of euro area assets than residents hold of foreign assets, so foreign selling will inevitably dominate.
He saw the euro at $1.25 in the first half of 2012.
The latest drop comes as speculators have piled into bearish positions against the euro, leaving scope for a short-term bounce as some unwind those positions to book profits.
We're slowly grinding lower in the euro but it's not a huge collapse, said Pierre Lequeux, head of currency management at Aviva Investors, whose parent Aviva plc manages $371 billion.
He said the most likely scenario was for the euro to strengthen if, as he expects, a credible solution to the crisis is found.
However, Commodity Futures Trading Commission data shows currency speculators net euro shorts fell to 95,814 contracts in the week ended Dec 6 from 104,302 contracts a week earlier.
The last time net short positions were above 100,000 was in mid-2010 when the euro was trading below $1.20.
The market is already short in spot and massively short in options, so mid-December we start to flat line around $1.29-1.32 into year-end, said Geoff Kendrick, strategist at Nomura, adding he anticipated renewed euro pressure in the new year.