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Dollar could be on the verge of break out, as stocks get pounded

Piotr Powietrzynski | Photolibrary | Getty Images

As stocks spiral lower, strategists say the dollar may finally be ready to flex some muscle.

Concerns the Fed could tighten policy combined with worry about Argentina's default and sharp declines in Europe to drive U.S. stocks more than 1 percent lower Thursday. The market was on track for its worst monthly performance since January.

The dollar index, however, was trading close to its highest level in a year Thursday and is up 2.2 percent for the month of July, its best monthly performance in 17 months.

"This is what everybody's been waiting for," said Marc Chandler, chief currency strategist at Brown Brothers Harriman. "No matter what currency you look at, the dollar is trading at higher levels. The euro is falling because shorts are jumping in, and sterling is falling because longs are liquidating. What's driving this is the Federal Reserve is moving towards its mandate, which will allow it to raise rates next year."

The dollar has gained this week as interest rates move higher, particularly at the short end of the curve where yields are at multiyear highs. Rates jumped on Wednesday's report of strong second-quarter GDP, showing a 4 percent pace of growth—well above the 3 percent expected.

Read MoreStrong second-quarter growth sparks rate hike talk

A report Thursday showing the first sign of wage pressures since the recession also added to the trend and speculation the Federal Reserve may have to speed up plans to raise rates. The employment cost index rose 0.7 percent for the second quarter, above the 0.5 percent expected and the fastest pace in six years. The report helped support interest rates, boosted the dollar and weighed on stocks. Interest rates later retreated as the selling in stocks increased.

European stocks were sharply lower on weaker-than-expected inflation data, more worry about huge losses at Portugal's Banco Espirito Santo and a big warning from Adidas that its business in Russia is hurting earnings.

Chandler said there are factors that should help the dollar stand taller, against the euro but also other currencies.

"Not only is central bank policy diverging, interest rates are diverging, and we're going to learn GDP is diverging," said Chandler. "The divergences between the U.S. and euro zone is a long time coming, and people expect that to drive the dollar higher against the euro and now it's beginning to kick in."

The Fed is ending its tapering of bond purchases in October, and the markets have been rife with speculation about when the central bank will move to normalize rates. The consensus is late in the second quarter or third quarter of next year, but some traders have been gaming a Fed that could be forced to move sooner because of an improving economy.

At the same time, the European Central Bank is moving toward looser policy and the economy there has been squishy.

"The Fed is the overriding factor but the underpinning of a weak Europe got the ball rolling. We had two failed rallies yesterday, and I think people are waking up to the fact the Fed is going to be a much bigger influence now," said Peter Boockvar, chief market analyst at The Lindsey Group.

Chandler said there is some disbelief that the dollar is ready to strengthen. "Even though the charts are showing a stronger dollar, people have been burned so many times, they're hesitant to jump in right now," he said, noting that ahead of the employment report traders often "buy the rumor, sell the news" and that could be at play. The July employment report is expected at 8:30 a.m. EDT on Friday.

He also said he is watching stocks with some concern. "Last Thursday, the S&P made new highs. Friday we gapped lower, and we haven't filled that yet," he said. The S&P 500 tanked 26 points to 1,943, a move that accelerated after the index broke the key 1,950 level.

"We have been dollar long since April," said Jens Nordvig, global head of G-10 currency strategy at Nomura. "We want to actually increase the size of those types of strategies. We're going to get pretty aggressive now."

Nordvig on Wednesday said he was doubling long dollar exposure in his recommended portfolio and said he expects the dollar's recent gains to accelerate. The August through October period should be crucial because it is likely during that time that there will be a shift in Fed communications, he noted.

He said his call was not based on the Fed statement, released Wednesday, but the fact that the central bank is getting closer to its targets and that will be the message from more Fed members in coming weeks. Those more hawkish voices could help drive the dollar higher—and the euro lower. He said the euro could hit 1.30, from its current 1.33 level.

Read MoreUS economy sizzles in Q2

"I think the trend is your friend," said Alan Ruskin, head of G-10 currency strategy at Deutsche Bank. "The themes in terms of higher rates and bringing forward Fed tightening in the past 24 to 48 hours I think are accurate."

Ruskin said the dollar has been trending higher, but that he sees it in a moderate bull cycle that should push it about 5 percent higher against major currencies in the next 12 months.

Read More'Overvalued' sterling tipped for a fall

"It feels like for the first time there's been a momentum shift in the currency maket," said Moody's Analytics' chief economist, Mark Zandi. "If we're right and we've jumped to a new level of growth in the U.S. and Europe is still kind of stuck in the mud then that would suggest the euro is going nowhere fast ... this is what we've been waiting for."

Dollar/yen was at 102.7.

"People have been very short the yen, and they've cut in half the short yen positions so the dollar's rise against the yen right now is not speculatively driven," Chandler said.

By CNBC's Patti Domm

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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