The dollar is approaching its strongest levels this year amid problems in Europe

The dollar has neared its strongest level this year as fiscal strains and renewed political uncertainty in Europe boosted its haven appeal, Bloomberg reports. At the same time, the currency’s relentless gains are fueling concerns that the rally is becoming overstretched.

The Bloomberg Dollar Spot Index climbed as much as 0.4% on Monday as the euro weakened. The index has now risen for more than three consecutive weeks. It is at overbought levels according to several measures, indicating that it may soon face a reversal, Bloomberg warned.

A slew of important U.S. economic data could determine the duration of the dollar rally: this week will see a services PMI reading, labor-market data, and the University of Michigan consumer sentiment index. Markets will focus on signals about the Fed’s next rate decision, Bloomberg noted. The Fed will also release the minutes from its September meeting this week, when it raised rates for the first time in three years.

The European currency fell to a 17-month low on Monday following the announcement of a snap parliamentary election in Spain and amid continued investor concerns about France’s debt and the country’s upcoming presidential election. Although FX market observers expect the euro to weaken further, many acknowledge that its recent selloff has been driven by strains in Europe’s bond market and could fade if those pressures ease, Bloomberg writes.

The euro’s decline against the dollar was also relatively contained compared with the falls in the Swiss franc and Norwegian krone, Bloomberg points out. This suggests that investors are using currencies other than the dollar to bet against the euro.

"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 taking long positions in the British pound and the Swedish krona against the U.S. currency. Renewed concerns about Washington’s own fiscal health could also knock the dollar off its highs.

The dollar’s latest rally has also prompted caution at Morgan Stanley, which recently shifted to a bullish stance on the U.S. currency. “We are concerned that a sudden increase in dollar-negative risk premium could lead to a ‘stop out’ of dollar long trades,” Morgan Stanley FX strategists led by David Adams wrote. “The result is we would look to buy the dip, rather than buying at current levels.”