The dollar becomes the market's crystal ball on US rates

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Forget stocks and bonds; the currency market is looking into the future of monetary policy.

The dollar index is sitting at the highest levels since summer 2010, coming off a 10th consecutive week of gains. Data from the Commodity Futures Trading Commission showed last week that hedge funds and other large speculators are holding a decidedly bullish $31.42 billion net long position.

So why the sudden and sharp move higher for the U.S. currency, even as the Federal Reserve last week said it would keep interest rates low "for a considerable time"?

Arguably, the currency and bond market may have been more focused on the so-called dot plot, which showed some Fed officials projecting interest rates will have to rise faster when the time comes next year. After Fed Chair Janet Yellen made her case, the dollar index shot up with bond yields, and equities soared to new highs.

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It's the economies, stupid

What's behind the dollar's muscularity? Economists say the greenback's new fans are reacting to growing confidence in the U.S. economy.

"The strength is telling you something about how the FX market is assessing the relative economic outlook in the U.S.," according to Gluskin Sheff's chief economist, David Rosenberg.

At the same time, interest rates in the U.S. have remained relatively stable. They have risen modestly, but have failed to match the dollar's torrid gains. The 10-year note yield, for instance, is off the low of 2.33 percent seen at the end of August.

"There is no doubt that the dollar has moved more substantially than U.S. interest rates," said Jens Nordvig, managing director and head of fixed income research and global head of currency strategy at Nomura.

"From a global perspective, there is a bit of a conundrum. Why is the dollar so strong, when rates are so relatively stable?" Nordvig asked.

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A 'structural recovery' for the dollar?

Although explanations differ, strategists say it has to do with how the U.S. economy looks when compared with the dour outlook in places like Japan, Europe and China.

The 12-nation euro zone "is perilously close to outright deflation and another recession," Gluskin Sheff's Rosenberg said. "Wage stagnation in the U.K. for the first time in five years is causing a reassessment" of the Bank of England's monetary policy, he said.

Meanwhile, "Japan has not emerged unscathed from the April sales tax shock, [with] China slowing down far more than expected and property prices deflating for four months running."

Steven Englander, chief FX strategist at Citigroup, said last week that the outsized move in the currency market might have to do with the harmful impact of higher interest rates on other economies. The move, he wrote in a research note to clients, "may be explained by the benign implications of the Fed's indicated fed funds path for the U.S. and the not-so-benign implications for other countries."

Nomura's Nordvig says the dollar is sniffing out higher interest rates and leading the way for other financial markets.

"I think the FX market is looking ahead, and seeing a dollar which is in structural recovery, and which will eventually get support from rate hikes," he said, even if the timing of tighter monetary policy is uncertain. That would match the greenback's historical tendency to foreshadow tighter Fed monetary policy.

"The dollar tends to move about six to nine months before the first rate hike by the Fed," Nordvig added. "We are in that period now, and it fits with dollar dynamics in the past three tightening cycles."

The upshot is that the world's largest economy is stronger than its major counterparts, and that eventually will translate into higher rates. Although analysts are divided about whether the dollar is reflecting out performance of the economy, or whether it's pricing in higher interest rates faster than other markets, most agree that these gains are likely here to stay.

"The Fed exit from [bond buying] and zero interest rate policy will be so contrasting from the need for further easing in Japan, Europe and China that even if it doesn't go in a straight line, the dollar should be able to move higher, said Kit Juckes, head of foreign exchange research at Societe Generale.