NEW YORK ( BBH) -- The dollar's strong rally in the first week of the year seems like ancient history now, overtaken by the swing in interest rate expectations and sentiment toward European officials' ability to get ahead of the curve of market expectations.

We are less sanguine about these developments, but see little indication that the pendulum is done swinging. Patience is required if one shares our views.

We had expected the dollar to recover after quantitative easing round two was announced, but the euro's run-up ahead of the announcement was a little more than we had expected. At the time we identified three indicators: interest rate differentials; pricing in the options market (risk reversals); and technical indicators (five- and 20-day moving averages).

As we have noted, the two-year interest rate differential continues to move against the dollar. The marginal change is more important than the absolute level, but the point is that one has to pay a growing amount for being long dollars.

Looking at technical indicators, outside of the proximity of the retracement objective near $1.3740, there is little sign that the advance is exhausted. The gaps between the five- and 20-day moving averages continues to grow, illustrating the strength of the move. Momentum indicators also are still rising.

In terms of market positioning, we think that the first part of the move was position-squaring after the November/most of December dollar rally and into the first week of January. The net speculative positions in the IMM futures saw what appears to be the biggest weekly swing on record through the week ending last Tuesday of roughly $5 billion notional value. However, the net position was only slightly long euro futures. Though the subsequent gain looks like the accumulation of longs, positioning does not appear near extreme.

Indications from the options market may be the only yellow light flashing for the euro bulls. Since late 2009, the market has paid a premium for euro puts over euro calls equidistant from the forward strike. That premium has fallen as the euro has climbed but the premium was the smallest on Jan. 14 and thus has not confirmed the latest leg up in the euro. In October 2010, there was roughly a three-week lag between the risk-reversals and the euro's sharp decline.

On balance, there is little at the momentum to encourage picking a top to the euro. A convincing move above $1.3840 could spur another 1% rise in short order.
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