Dear Subscriber,

There's been a strong move against the U.S. dollar this week. But am I envious of the euro right now? Definitely not.

Technically the dollar is extremely overbought. So I expect a decent, near-term correction upward in the euro. However, according to my analysis, the euro is set to weaken substantially against the U.S. dollar over the next several months.

That view is based on three long-term global economic themes in place that should continue to hammer away at the Eurozone economy and expose the flaws in the European Exchange Rate Mechanism.

Threat to the Euro #1:
Certain emerging European economies, not already part of the European Monetary Union (EMU), are looking at the euro and kicking themselves.

Why?

Before a country can adopt the Euro, it must gain acceptance into the Eurozone.

They didn't make the effort to adopt the euro as their currency of choice.

You see, a country must first gain acceptance into the Eurozone before it can adopt the euro.

And back when everything across emerging markets was all hunky-dory, acceptance would have been relatively painless. Growth wasn't a concern. Yet emerging nations stuck with their existing currencies, which had no trouble maintaining or even gaining value.

But times are changing. Global demand is waning. And some economies in Central and Eastern Europe are wailing for help. Their lopsided growth model — over-reliant on global capital and under-reliant on domestic demand — is keeling over on them. And their currencies can't support the unexpected weight.

Here's a comment from someone who agrees with me: Andras Simor, president of the Hungarian Central Bank, said recently, "Hungary's scope for interest rate cuts is limited because of the risk of a very significant devaluation of the forint."

So it's no surprise to me why the average Hungarian citizen would rather be holding the euro instead of the forint.

The specter of the Central European countries being inducted into the system has many worried, including me.

Some analysts have looked at the recent clamoring by Central European economies to adopt the euro as a sign the Eurozone is becoming a safe haven.

True. Relative to Central Europe, the larger countries in the Eurozone are safe. But, this excerpt from a recent story carried in Bloomberg sums up the dilemma the Eurozone is facing:

"The dilemma for the European Central Bank (ECB) is that, while the desire to join the euro region is greater, qualifying is becoming harder: Membership requires countries to meet targets for inflation, budgets, currencies and interest rates — a tall order in the middle of a recession.

"Allowances have been made before. Greece assumed membership in 2001 on data that proved to be fudged. Inflation rebounded in Slovenia after it joined last year.

"'The consequences of similar compromises would be greater now,' says Paul Donovan, an economist at UBS AG in London. 'Enlargement would expose the euro area to more bank failures and make it harder to manage a one-size-fits-all monetary policy.

"'While smaller countries outside the euro are more willing to join as a result of the crisis, the rest of the euro zone may be less willing to contemplate their admittance,' he says.

"'A widening gap between the region's weakest and strongest economies would add to concern about a breakup. Harvard's Feldstein says individual nations could still leave the euro bloc if they find monetary policy too tight or fiscal rules too onerous.

"'The global economic crisis provides a severe test of the euro's ability to survive in more troubled times,' he wrote in a column last month. He said the growing gap between interest rates on German bonds and on those of more heavily indebted Italy suggests investors 'regard a breakup as a real possibility.' The gap, or spread, has more than quadrupled in a year to 1.4 percentage points."

No doubt acceptance into the union is the best path for developing nations of Central Europe. But acceptance of these countries and the impact on the euro are quite another thing.

Threat to the Euro #2:
Eurozone's Banks Overexposed to Risk

Even without the additional baggage of adopting Central European developing countries, Europe is already tied tightly to them through its huge exposure throughout the zone's banks.

Among Eurozone member countries, Austrian banks happen to be the most overexposed to emerging market loans. In fact, their current level of exposure sits around a staggering 85% of their GDP.

I don't think the global economy will find a way to rebound quickly. That means this massive exposure has the potential to wreak havoc on Austrian banks ... as well as those in a similar but somewhat less severe position.

Austria recognizes the kind of trouble they could be in for, so they may look to the EMU for assistance. But not all members may want to come to Austria's aid.

So while it's a major concern, the EMU lacks credible cross-border policies to handle such problems. And should EMU officials flounder, they could end up reading requests from members asking to get out of the deal.

The result: An unstable monetary union that absolutely cannot be good for the euro.

Threat to the Euro #3:
Rattled Consumers Will Need
Some Serious Time to Heal ...

The fallout from the credit crisis is making people think twice about handing over their hard-earned cash. Part and parcel to the downfall of Emerging Market growth models is the developing trend (in the developed world) towards saving. Gone are the days when consumers were willing to dish out cash for any old item.

Households are being hit on all types of investments they've made, including real estate, stock purchases, insurance, etc. This undermines consumer wealth and hugely influences confidence and behavior.

Martin explained very well what these deflationary forces might mean in his Money and Markets column on Monday.

There's little doubt consumers are pulling back on their spending rather quickly. The numbers are there to prove it. And there's a major divergence that proves a change in attitude. Even while disposable income has been rising at a healthy pace over the last couple quarters, consumption is falling. As an economist would say, the marginal propensity to consume is declining.

The reserve currency most often benefits in a deflationary environment.

This is why I believe the fundamentals globally won't change quickly. The frivolous spending and insatiable appetite for stuff won't return after a few banks get plucked out of the water, or the Big Three get a handout, or people start slaving over superfluous bridges and aqueducts. Rattled consumers need time to lick their wounds. And deflation is currently the bigger near-term threat.

The reserve currency most often benefits in such a deflationary environment. This is why I expect we'll see the U.S. dollar benefit and the euro suffer.

Best wishes,

Jack