Renewed fiscal pressures and political uncertainty in Europe have once again heightened demand for the dollar as a safe-haven asset, driving the greenback toward its strongest level of the year. However, the sustained gains have also sparked concerns among market participants about whether this rally has become overextended.
The Bloomberg Dollar Spot Index rose as much as 0.4% at one point, while the euro weakened. The dollar thereby extended a three-week winning streak, and a dense slate of U.S. economic data due in the coming days could determine how much longer this rally can last.
By some measures, the index has already entered overbought territory, suggesting the dollar may be due for a pullback. The outlook for U.S. interest rates will take center stage, with the ISM services PMI, employment data, and Friday's University of Michigan consumer sentiment reading all scheduled for release this week. Investors will also be watching the minutes from the Federal Reserve's last meeting as well as speeches from several policymakers. The Fed implemented its first rate hike in three years at that meeting last month.
"An overbought dollar with stretched valuations could be vulnerable to any disappointing U.S. data this week, particularly if those data prompt investors to reassess the strength of the hawkish consensus within the Federal Open Market Committee (FOMC)," said Valentin Marinov, head of G10 FX research and strategy at Credit Agricole. A model at the bank currently recommends going long on the British pound and Swedish krona while shorting the dollar.
The euro's weakness combined with expectations of further U.S. rate increases have together propelled the dollar higher. Nevertheless, some market participants believe the dollar could reverse course if investors begin to question the Fed's policy path. Forecasters have also warned that a renewed focus on the United States' own fiscal position could send the dollar lower from its elevated levels.
Although FX forecasters expect the euro to weaken further, many also acknowledge that the recent selloff in the single currency was primarily driven by stress in European bond markets, and that the decline could reverse if those concerns ease. Compared with the declines against the Swiss franc and Norwegian krone, the euro's drop against the dollar has been relatively limited, indicating that investors are not solely choosing the dollar as the counterpart currency when building bearish positions.
The dollar's latest leg higher has also prompted Morgan Stanley to turn cautious. The bank had only recently turned bullish on the dollar. FX strategists led by David Adams wrote in a report: "We worry that a sudden rise in the risk premium against the dollar could trigger stop-losses on long-dollar trades. Given this, we prefer to wait for a pullback before buying rather than purchasing at current levels."