U.S. dollar bulls are enjoying their moment in the sun after a trying start to the year, and analysts told CNBC the good times could continue.
The greenback strengthened to a seven month high against the yen in early trade on Wednesday, while the U.S. dollar index, which tracks the dollar's value against seven major currencies, has rallied nearly 4 percent since the beginning of July on positive U.S. economic sentiment. On Tuesday, the index hit an over one-year high of 82.930, following lackluster performance in the first four months of the year when it slumped 1.2 percent.
Expectations that U.S. monetary policy will continue to diverge from policy in Europe and the U.K. will send the dollar index higher as investors price in a U.S. rate hike, according to Capital Economics.
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"The dollar is now the strongest it has been against the other major currencies in over a year. But we doubt its rally is over given the relative prospects for monetary policy in the U.S. and elsewhere," analysts at Capital Economics, wrote in a note published Monday.
"By end-2015, we expect the dollar to have strengthened further to $1.25 against the euro, to $1.60 against sterling, and to 120 yen," they added.
The greenback was trading at $1.3121 against the euro, $1.6584 against and at 104.81 yen on Tuesday.
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Diverging policy
The Federal Reserve sparked rate hike speculation in mid-2013 when it unveiled plans to taper its quantitative easing program. But the timing of a rate hike remains uncertain.
Last month's Fed minutes showed some policy committee members want to hike rates promptly amid improvements in the economy. Yet, most members feel that more data are required before taking action.
By contrast, European policy looks dovish. Expectations for a Bank of England rate hike this year faded amid concerns over weak wage growth, while the European Central Bank is widely expected to pursue quantitative easing.
"We now broadly concur with the market's view about the future path of interest rates in the U.K. following the recent change to market expectations. And we also agree with the widely-held view that rates in the euro-zone will remain at rock-bottom for a long while yet," said Capital Economics.
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"Nonetheless, we continue to think that investors are being too sanguine about the outlook for interest rates in the U.S. and that the Fed will tighten monetary policy more aggressively than most envisage as a strengthening labor market puts upward pressure on wage inflation," the analysts added.
The mighty greenback
"Our central view is that the dollar will continue to move higher," said Ray Attrill, co-head of FX strategy at National Australia Bank.
If the Fed adopts a slightly more hawkish tone at its next meeting investors could begin pricing in a rate hike in the second quarter of 2015 rather than the second half, boosting the greenback, he said. "The next Fed meeting is potentially going to be the catalyst for a fresh lift higher."
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However, he acknowledged downside risks: "If the statement this month [is] a carbon copy to the June comment - if they repeat that language the risk there is that the front end of the U.S. curve will move to price out some of the 2015 tightening that it's been pricing in in the recent weeks."
Standard Chartered's Callow expects the dollar index to rally through year-end, but said the dollar would not do as well against some major Asian currencies.
"Our forecast is $1.27 for euro and 106 for dollar-yen motivated by a better economic performance in the U.S., in contrast with weaker performance in Japan and the euro zone," he said. "It comes down to better fundamentals."