FORTUNE — Investors have been unnerved for more than a year now about the future of the embattled euro zone. Bond yields for the zone’s troubled peripheral countries soared, as investors lost faith that Greece and others would be able to pay back its huge debts. And as Europe’s ongoing crisis seeped into bigger countries like Italy, yields skyrocketed, leaving the troubled nation to scramble for bailouts. On the opposite end of the spectrum, Germany’s bond yields have now fallen below zero, meaning investors are not only willing to forgo returns on their money, but they will pay in order to keep it safe.
Surprisingly, however, for most of last year, the panic couldn’t bring the euro down. Up until recently, Europe’s common currency traded at $1.34 against the dollar – roughly where it was in 2007 before the crisis unfolded and just shy of where it was at the start of 2011.
But the euro’s unexpected strength has begun to wane and analysts predict 2012 could very well test the currency’s resilience. This follows the European Central Bank’s move in December to allot $643.18 billion in the first batch of its 3-year loan program to 523 banks in the euro zone to support lending and expand liquidity. Perhaps more importantly, the declines in the euro come as the economic outlook in the U.S. has started to markedly improve.
In December, the euro lost 3.6% against the dollar. It ended 2011 as the worst performing major currency, spiraling to a one-year low against the greenback and a 10-year low against the Japanese yen. The euro’s drop has sparked a renewed surge in bets against the currency. In the week ending December 27, the number of short positions, whereby investors gain from a decline in prices, outnumbered long position by 127,900 contracts, according to the U.S. Commodity Futures Trading Commission. That’s a record and up from 113,700 contacts the prior week.
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Barclays joins Nomura Group and other firms with a negative forecast for the euro. During the next six months, Barclays predicts the euro could fall to $1.20. Currently, the currency is trading at $1.2779 after an overnight bounce off of a 16-month low of $1.26.
The most immediate factor putting downward pressure on the euro is Europe’s deteriorating growth prospects for 2012 against a modestly better outlook for the U.S, says Jose Wynne, the bank’s North America head of foreign exchange research. While he forecasts that the U.S. economy will grow 2.5% in 2012, Europe’s troubled peripheral nations (especially Greece) could have a tough time repaying debts as the region is forecast to undergo a moderate recession with growth contracting 0.2%.
On Monday, German Chancellor Angela Merkel and French President Nicolas Sarkozy met in Berlin to discuss the euro zone’s plans to tackle the debt crisis. But worries that Greece’s deteriorating economy could threaten the viability of its bailout package overshadowed any progress of the talks.
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“Before September economic activity was still pretty strong in Europe,” says Wynne, adding that downward revisions for growth outlooks applied not just to Europe but other major countries such as the U.S. and China.
Few are predicting the worst case scenario – that is, a full-blown break-up of the euro zone.
But that doesn’t mean some aren’t ruling the possibility out. In a January report, Nomura foreign exchange strategist Jens Nordvig said a break-up could play out two ways. First, it could happen gradually, whereby a political setback in Greece and/or Portugal lead the countries to miss requirements demanded by the European Union of its rescue packages. In that case, Nordvig noted, the euro will likely remain in existence since only a few smaller countries would end up adopting their own new national currencies.
The less likely scenario – albeit, not entirely implausible – is the case of a full-blown break-up in the event that larger euro zone economies such as Italy default. The euro would then cease to exist, the European Central Bank would be dissolved and all euro zone countries would convert to new national currencies or perhaps form new currency unions with new currencies and a new central bank.
“European policymakers continue to argue that they will do ‘what is needed’ to save the euro,” Nordvig noted in his January report. “But the genie is out of the bottle, and various break-up scenarios are now being discussed more openly.”
The question is how a potential break-up could unfold.
