Market Extra: 3 reasons why the dollar rally’s days may be numbered

The U.S. dollar is putting in impressive gains this year, but some analysts are convinced the rally is about to run out of steam with midterm elections looming, the Federal Reserve moving closer to the end of its tightening cycle and amid signs Europe could be moving toward a resolution of its infighting.

After a strong second quarter, the dollar has cooled a bit against its developed-world peers. Still, the ICE U.S. Dollar Index DXY, +0.42% which measures the currency against six major rivals, remains up 3% for the year to date, bouncing back after a 10% drop in 2017.

“The dollar is overcrowded and overbought and could see a correction in the fourth quarter despite two more rate hikes,” said Aaron Hurd, senior portfolio manager in the currency group at State Street Global Advisors.

Here’s a look at the three factors that could weigh on the U.S. currency in coming months:

Midterm fallout

Midterm elections, in which Democrats are seen with a strong chance of taking control of the House and an outside chance of taking the Senate, loom in November. The dollar could be vulnerable in the run-up and the aftermath.

Read: Will midterm elections sink the stock market? Here’s what history says

Natixis chief economist Joseph LaVorgna put the highest probability — at 55% — on the Republicans retaining a narrow majority in the Senate while losing control of the House, adding that “uncertainty is high as polls may not provide an accurate picture of the current trends.”

Also see: Here’s how stocks perform around midterms, in one chart

“A divided Congress should produce more uncertainty on trade, less chance of additional fiscal stimulus and probably some political noise but without much consequences for the current economic dynamics,” LaVorgna said.

Fed rhetoric

The Federal Reserve has been raising interest rates since the end of 2015, so far delivering eight increases. On Sept. 26, another 25 basis point hike is expected with CME Fed funds futures predicting it at a 97.4% chance. Another increase in December is given a 78.5% probability.

That means the dollar could be vulnerable to a change in tone from policy makers.

“If the Fed switches its rhetoric from accommodative to neutral, the dollar could weaken,” said Alessio de Longis, portfolio manager at OppenheimerFunds. “When the rhetoric changed in 2005, the dollar peaked even though there were still more rate hikes to come.”

Market participants expect up to another three rate increases in 2019, but then the central bank could take its foot off the gas pedal. This means the Fed’s rhetoric could adjust its language as early as next year, and the greenback’s price doesn’t reflect that yet, de Longis said.

Good news from Europe

The euro EURUSD, -0.4790%  is the dollar’s most important rival, and the popular ICE dollar gauge is heavily skewed toward the shared eurozone currency. The euro has been held back by various reasons, including interest rate differentials given the European Central Bank said it wouldn’t raise rates at least until summer 2019.

But local political turmoil, including uncertainty over Italy’s budget plans, has weighed on the currency. If Italy manages to resolve its budget issue, that is pass a budget that also falls in line with EU deficit rules, thereby avoiding confrontation with Brussels, the euro could see a rally, de Longis said. And a euro rally would come at the expense of the dollar.

Read: Relief rally for Italian bonds overlooks potential budget snags, say analysts

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