The most important sign a dollar breakout is coming

The dollar's momentum against the Japanese yen is the key to the dollar rally.

The dollar index has been on the move since Friday, but the greenback has been rising against the yen since Thursday, and its ability to keep that rally going will be the test. Dollar/yen was at 123.85 midday Wednesday and temporarily broke through 124, a key psychological level not seen since June 2007.

If the market can hold above 124, it would be an important statement. "That will really influence currencies. Yields have moved ahead of it and stabilized, and dollar/yen is going to be the one that will really move. This would basically be the market becoming convinced the dollar rally is unstoppable," said Boris Schlossberg, managing director, foreign exchange strategy at BK Asset Management.


Source: FactSet

"Dollar/yen hasn't been above 124 in eight years. The fact we crossed that is very important. It sends shock waves across the market and it shows the U.S. dollar is back on a growth path," Schlossberg said. "The really big question is how much juice is left in the trade, having gone so far so fast."

Schlossberg said the next catalyst for the pair could be revised first quarter GDP, expected Friday. The number is expected to show contraction, but if it is even slightly better than expected, that could keep the dollar rally going.

If the 124 level holds, his next target is 125.

"At this point, that's the big breakout in the dollar move. That's the multi-year high. That's the market conviction on the rate front because dollar/yen really moves on rates. If the market is convinced, rates are indeed rising on the short end of the curve that pushes the dollar forward against everyone," Schlossberg said.

BNP Paribas currency strategist Vassili Serebriakov said a technical level traders are watching is 124.14, just above the 124.07 reached Wednesday afternoon. He said dollar/yen is the cleanest trade on U.S. rates.

"The reason it kind of moves as much as it did over the last several days... is our positioning indicator was telling us people were the least short of yen since the start of Abenomics," he said.

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Short-end U.S. rates have been on the move more aggressively than the long end recently. That is helping to flatten the curve, a sign of higher interest rates ahead. The U.S. 2-year was yielding 0.66 percent Wednesday, and the 10-year was at 2.16 percent, higher but below recent highs.

The dollar and euro have been seesawing Wednesday on fluctuating expectations of a Greek debt deal, but Schlossberg said the market is really moving on U.S. rate expectations. Fed Chair Janet Yellen strengthened her message that a rate hike was likely this year in comments Friday, he said.

Marc Chandler, head of foreign exchange strategy at Brown Brothers Harriman, said talk of a rate hike from Fed Vice Chairman Stanley Fischer also helped fuel the dollar's gains Tuesday, as does some signs of improved data from the U.S. The dollar is firmer against the euro, but it could consolidate its gains ahead of some key events next week, such as the European Central Bank rate meeting and the Friday U.S. employment report.

Read MoreFed rate hikes may trigger volatility - Fischer

But what will keep the dollar rally going is the difference between the U.S. Federal Reserve's moves towards tightening as other central banks, like the ECB and Bank of Japan, remain easy.

"The divergence of monetary policy gives the dollar rally longer legs – if not in time, in magnitude," Chandler said.

Strategists believe the euro is on its way to parity with the dollar after a two-month rally, but Schlossberg said that road will be volatile as a deal on Greece is worked out.

Read MoreEuro stocks rally on word of Greek accord