The dollar rose to a five-month high against a basket of major currencies on Friday, helped by weakness in the euro as investors fretted about political uncertainty in Italy.
The dollar index has gained for five straight sessions and is on track for a 1.3 percent weekly gain. It has risen 5 percent since mid-February, with investors betting U.S. interest rates will need to rise further to curb inflation.
Shaun Osborne, chief FX strategist at Scotiabank in Toronto, however, believes the dollar's rally was more about extreme short positioning that needed to unwind.
"We continue to view dollar gains as a temporary issue reflecting excessive short positioning and concerns European growth momentum has slowed and may impair the ECB's (European Central Bank) willingness to move away from quantitative easing later this year," Osborne said.
The euro on Friday was headed for its fifth successive weekly decline versus the dollar, its first such fall since 2015. Europe's single currency has fallen about seven cents in three weeks amid a sharp dollar rally and concerns about the outlook for Italy's next government.
The far-right League and 5-Star Movement have agreed on a governing accord that would slash taxes and ramp up welfare spending. Ratings agency DBRS warned on Thursday that the economic proposals of the anti-establishment parties could threaten Italy's sovereign credit rating.
In mid-morning trading, the euro fell to a five-month low of $1.1753. It has declined nearly 1.2 percent versus the dollar this week and dropped against the Swiss franc, which typically attracts capital in times of uncertainty.
"The possibility of a eurosceptic government in Rome is shaking investor confidence ... at this point a larger fiscal deficit and greater bond issuance (in Italy) does seem likely," said David Madden, a strategist at CMC Markets.
A founding member of the EU and the euro, Italy accounts for 15.4 percent of eurozone GDP and the Italian parties' hostility toward the European Union is the biggest challenge to the bloc since Britain voted to leave two years ago. A powerful rally by the dollar is also hurting the euro.
On Friday, the dollar set a fresh four-month high against the yen and was up 0.1 percent, buoyed by a further rise in U.S. Treasury yields that suggests an upbeat outlook for the world's largest economy.
In a note to clients, however, strategists at Citibank said the dollar rally would not last long. They cited the U.S. budget deficit, which is projected to balloon to more than $1 trillion in 2019, and would contribute to a 5 percent drop in the dollar index over the next 12 months.