Why the Dollar’s Gains May Be Limited

Notwithstanding its recent decline, it’s hard to deny that the dollar has had quite a magnificent run this 2013. Looking at the dollar index, we see that the American currency began its impressive rally once the markets opened in January, and it has hardly looked back since.

USDX Chart

Of course, you’re probably already fully aware that the dollar has been sourcing its strength from the Federal Reserve’s views on monetary policy. In recent months, the markets have been abuzz with talks of the Fed winding down its monthly asset purchases.

Its shift on how it views stimulus has made the Fed considerably more hawkish than other major central banks (ECB, BOE, and BOJ, I’m lookin’ at you!). Consequently, this has made the dollar more attractive that its major counterparts.

But some are beginning to wonder just how much upside is left in the dollar’s rally. Below are three factors that may limit the dollar’s gains in the long run:

1. QE-tapering expectations have been largely priced in.

Let’s face it — we’ve been talking about tapering since the Wall Street Journal spilled the beans on the Fed in the first quarter of the year. Since then, the dollar has put up impressive gains, most notably after the June FOMC statement.

Talk of winding down stimulus is pretty much old news and many believe that the dollar’s current trading levels already reflect a great deal of these QE-tapering expectations.

2. The Fed won’t be raising interest rates any time soon.

In his speech on Wednesday, Ben Bernanke made it clear that even if the central bank does decide to cut off its asset purchases by next year, it won’t be hiking up its benchmark interest rates any time soon.

In the past, the Fed has declared that it won’t be increasing rates until unemployment hits its target of 6.5% (it’s currently at 7.6%). But according to Bernanke, that doesn’t necessarily guarantee an increase from the current near-zero levels, and the Fed may still decide to keep interest rates at its accommodatingly low levels for a long time.

3. The euro has been resilient.

For the dollar index to rise, the Greenback needs to gain against the euro, as the shared currency makes up about 57% of the index. But doing so is easier said than done, as the euro has been quite resilient as of late.

In fact, even in the heat of the debt crisis, it didn’t tumble so dramatically, considering that the euro zone was arguably on the verge of breaking apart.

Some speculate that when it depreciates, the euro gets support from the People’s Bank of China, as the central bank sees the shared currency’s momentary weakness as an opportunity to diversify away from dollars. Others believe that the euro zone’s large current account surplus (in contrast to the U.S.’s huge deficit) is what keeps it afloat.

Don’t get me wrong, my forex friends. This isn’t to say that we won’t see further gains from the dollar. The way I see it, market conditions still favor the Greenback. It just seems unlikely to me that it’ll continue rising at the same pace that it did in the first half of the year.

But then again, that’s just my humble opinion. I’d love to hear what you think. Share your thoughts in the comment box below!