It's not about the stronger dollar…at least not yet

The stronger dollar may have stolen the headlines this week, with the best weekly gain in nearly two years.

And in fact, the dollar index, which measures the dollar's performance against a basket of other major currencies, mostly the euro, is sitting at the highest levels of the year.

But dig deeper into the action in the currency market over two days, and you'll see it's not in fact a broad dollar rally.

$100 dollar bills
Oscar Siagian | AFP | Getty Images

For all of the headlines about a strong dollar and the historic dollar rally Thursday, the greenback only strengthened against the euro, yen and pound. It actually weakened against the Canadian and Australian dollars and was little-changed against emerging markets currencies like the Brazilian real and Asian currencies, holding near recent lows.

The dollar index was trading lower Friday, as traders took profits after a weak August jobs report, but it was up 1.2 percent for the week Friday, the best gain since November 2013, and it is up 4.4 percent in eight weeks, its longest winning streak since February 1997.

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This week's action, however, highlights the fact that current foreign exchange market trade is not a dollar-driven move, and therefore not being dictated by the stronger U.S economic data, as widely reported.

Instead, the moves represent the latest front in the global currency war, in which central banks ease policy, reflate their economies, and directly or indirectly try to weaken their currencies to spur growth.

"This dollar move seems more in response to the tit-for-tat currency war among the four big currencies that the U.S. dollar is temporarily winning on a RELATIVE basis rather than a vote of confidence in the U.S. dollar more broadly speaking," according to Peter Boockvar, chief market analyst with the Lindsey Group.

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The latest salvo was fired Thursday by European Central Bank President Mario Draghi. Draghi managed to surprise investors, who already had high expectations for easing, by cutting interest rates and leaving the door open to full-blown QE, on top of the announcement of purchases of asset-backed securities.

The euro suffered its biggest one-day drop since 2011.

The British pound was another notable loser this week, falling almost a full percentage point from last Friday.

Again, the rationale centered around expectations for easier monetary policy.

"The concern is that ECB easing will discourage the Bank of England from raising interest rates prematurely especially with Euro-sterling trading near six-year lows," said Kathy Lien of BK Asset Management.

Japan is also on the front lines of the currency war as it continues to fight a sluggish economy and stir up inflation through monetary easing and expectations it will do more of it.

Thursday, the Bank of Japan sounded a more cautious note on the Japanese economy, while leaving interest rates unchanged.

The BOJ cut its view on housing investment, citing the impact of a sales tax increase in April. The central bank has signaled it's prepared to ease further if the economic outlook warrants, and hopes are rising as the economy shrank 6.8 percent in the second quarter on an annualized rate.

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So where does this all leave the Federal Reserve and the dollar?

Against the big three (Japan, U.K., Europe), the dollar is strong and the Fed looks hawkish, but against much of the rest of the world's currencies, the dollar is holding near recent lows, and the Fed still appears dovish and in zero-interest rate mode.


While the U.S. data lately—from manufacturing to trade to services—are showing stronger-than-expected growth, the Federal Reserve has yet to shift to a hawkish stance or provide any real signal that higher rates are around the corner.

For instance, Fed fund futures, which indicate the timing of when the market expects the Fed to raise interest rates, haven't moved much. Currently they predict 55 percent chance of a rate hike to at least 0.5 percent by July. U.S. 10-year Treasury yields, while off the lows, are still near the lowest level since June 2013.

For the dollar to benefit from better economic data across the FX spectrum, the Fed will have to change its tune, and with that will come the expectation of higher rates and a selloff in bonds.

"Emerging markets Asia (currencies) has generally been resilient in the face of a Euro-centric move, and is much more vulnerable to U.S.-dollar led price action, especially if the U.S. yields respond across the curve," wrote Alan Ruskin, chief FX strategist at Deutsche Bank.

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That's why further proof of a resilient U.S recovery will be critical to changing the Fed's view.

"Strong data should reinforce the uptick in FX volatility, and sets up for a very 'interesting' September FOMC, when the divergence between FOMC signals and fed fund futures is more likely to be resolved in favor of the Fed," Ruskin said.

In other words, if rates and Fed Funds futures move, the dollar may finally get the broad-strength traders are looking for to confirm this rally.

Jens Nordvig, head of fixed income research and global head of currency strategy at Nomura, expects it to start with the September Fed statement as well.

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"We believe the 'considerable period' language may be toned down or entirely removed, which will serve to weaken the Fed's forecast guidance," he said.

He downgraded his forecast for the euro to weaken to 1.27 by the end of September and sees the Fed meeting as the catalyst for further euro weakness and dollar strength.

Nordvig expects emerging markets currencies to finally weaken as the Fed shifts its tone.

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"We would be surprised if emerging markets currencies don't react to a new signal from the Fed and a shift in the U.S. yield curve," he wrote in a separate note this week.

"We think the timing is now right for entering long U.S. dollar positions versus selected emerging market currencies."

He favors the dollar against Mexico's peso, Malaysia's ringgit and Australia's dollar.

It all depends on Fed Chair Janet Yellen and her statement at the Sept. 16-17 meeting. If she continues to emphasize concerns about labor market slack, and interest rates on U.S. Treasurys continue to remain at rock bottom levels, it will remain up to the ECB and BOJ and others to control the directions of their currencies on their own.

The currency war rages on.

—By CNBC's Sara Eisen