Dollar Nears Strongest Level This Year as Cracks Emerge in Rally

The dollar neared its strongest levels this year as fiscal strains and renewed political uncertainty in Europe boosted its haven appeal, even as its run of gains stoked concerns the rally is becoming overstretched.

The Bloomberg Dollar Spot Index climbed as much as 0.4% as the euro weakened. That extended a three-week run of gains ahead of a slew of US economic data in coming days that may determine the duration of the rally. The index is at overbought levels according to some measures, indicating that it may face a reversal.

The US rates outlook will be in focus given a heavy schedule of readings that include the Institute for Supply Management (ISM) services PMI, jobs data and Friday’s University of Michigan consumer confidence numbers. Minutes from last months’ Federal Reserve meeting — when it raised rates for the first time in three years — and speeches by policymakers, will also be scrutinized.

“The overbought and overvalued USD could be vulnerable to any downside surprises from this week’s US figures, especially if they prompt investors to reassess the strength of the hawkish consensus at the FOMC,” said Valentin Marinov, head of G10 FX research and strategy at Credit Agricole. One of the bank’s models currently recommends long positions in the pound and Swedish krona versus the greenback.

A weaker euro and expectations for further US interest rate hikes have powered the dollar higher, though some see scope for reversal if investors start to question the Fed’s policy path. Forecasters also warn that renewed concerns over Washington’s own fiscal position could knock the greenback off its highs.

While currency forecasters expect further euro weakness, many acknowledge that its latest selloff has been driven by strains in European bond markets and could unwind if concerns ease. The single currency’s decline against the dollar has been relatively contained compared with losses in the Swiss franc and Norwegian krone, suggesting investors are looking beyond the greenback when it comes to bearish bets.

The dollar’s latest rally has also raised caution at Morgan Stanley, which recently shifted to a bullish stance on the US currency.

“We are concerned that a sudden increase in USD-negative risk premium could lead to a ‘stop out’ of USD long trades,” FX strategists led by David Adams wrote in a note. “The result is we would look to buy the dip, rather than buying at current levels.”