With a potential Fed rate hike as a tailwind, the dollar rally looks set to resume and it could be powerful.
Since last week, the dollar index has gained more than 2 percent. But its surge since Friday has some strategists thinking the greenback may have turned and will start leading again, fueled by the prospect of Fed rate hikes.
"I think the markets are rushing to get long dollars again, and I think the FX market is running ahead of rates again," said Vassili Serebriakov, BNP Paribas currency strategist. "It's a little bit of a concern, in that I think we need support from higher rates to keep the dollar moving higher. But just about now, I think it's about getting off the sidelines to get back into the long dollar trade."
One of the more dramatic moves of the dollar has been against the yen, which hit a more than 12-year low overnight of 124.30. The dollar index was also higher Thursday, as the euro slid back to $1.08.
"To us, it seems like that's the cleanest trade on U.S. rates. The reason it kind of moved 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," Serebriakov said, referring to the economics and easy money policy of Japanese Prime Minister Shinzo Abe.
Serebriakov and other strategists said the dollar's course could be determined in the next several days by a number of important events, not the least of which will be the May employment report June 5.
"It (the dollar) went sideways to lower for two months and look what happened. The euro just fell 6 cents in seven sessions," said Marc Chandler, chief currency strategist at Brown Brothers Harriman.
He said the reasons for the reversal include the European Central Bank decision to move up its bond-buying schedule ahead of the summer as well as recent comments from Fed Chair Janet Yellen and Vice Chairman Stanley Fischer about the potential for rate hikes by the U.S. central bank this year.
"Next week is going to be the mother of all weeks," said Chandler, noting there's an ECB meeting, jobs data Friday, OPEC gathering Friday and Australian central bank meeting Wednesday. On top of that, Greece has a debt payment due. This week, there is also revised first-quarter GDP Friday, and a G-7 meeting underway this week in Dresden, Germany.
The dollar could consolidate into the big events, such as next Friday's jobs data, said Chandler. If the employment report is solid enough, it could also launch the greenback on another move higher as traders speculate the economy could be strong enough to move up the anticipated timing of a Fed rate increase.
While a number of factors drove the rally, what will keep the dollar moving higher is the difference between the Federal Reserve's moves toward 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.
Boris Schlossberg, managing director, foreign exchange strategy at BK Asset Management, said Yellen was the biggest factor pushing the dollar higher. While her comments were not a new view from the Fed, Schlossberg said the fact that Yellen on Friday was more strident in comments about a rate hike helped send the dollar higher.
"She's the only one that matters. The chairwoman is now of the mind that, 'Yes, we are probably going to raise rates before the end of the year,'" said Schlossberg. "Basically her view is: 'It's just a matter of us getting a couple of better data points, and we're ready to go.'"
Schlossberg said he believes bond yields are actually leading the move higher in the dollar. The two-year yield has edged higher—to about 0.65 percent—in recent sessions, while rates at the long end stayed contained, closing the gap between the two—or flattening the curve. A flatter curve is seen as a sign of higher rates.
"I think the question is are we going back to those March/April (euro) lows of around $1.05," said Serebriakov. "I don't think it will be as fast as the last couple of days. At this point, we might need to wait until the next nonfarm payrolls before getting momentum, and from there, if the market reprices September, which we think is likely ... I think we should be back at those levels by the end of June."
The market is currently pricing in the first Fed rate hike for December, while previously it had been September. The expectations shifted slightly back toward September after Yellen spoke Friday.
The euro seesawed against the dollar Wednesday on a variety of headlines related to Greece's debt talks. That helped push the dollar index lower. But it was the move in dollar/yen that strategists were watching. Dollar/yen temporarily crossed above the psychologically important level of 124 for the first time since June 2007, setting the stage for Thursday's move higher.
Bank of Japan Governor Haruhiko Kuroda said early Thursday from Dresden that he does not believe major exchange rates deviate substantially from economic fundamentals.
But Serebriakov does not see the move in U.S. rates as being aggressive enough to support the dollar's recent rally. "Rates flattened since last week, but in terms of what's priced into the U.S. curve, it's still very dovish in terms of both the starting point and the trajectory."
He said the two-year had a high yield of 0.70 in March and it's still well below that. "If market's do start repricing, we should be breaking through that level," Serebriakov said. On Wednesday, buying in the long end of the curve drove the 10-year yield to 2.13 percent in late afternoon, while selling supported yields at the short end. The 10-year was flat Thursday morning, and the 2-year continued to find support above 0.64 percent.
Serebriakov said the dollar rally, if it continues, will be a different kind than that previously led by other central bank easing. The dollar index is up 21 percent in the last year.
"There's Greece, back and forth in terms of headlines. It moves the market intraday, but it's not very directional. We're really looking to the U.S. to give us direction," he said. "The question is, is this a different dollar rally. I think it should be if the Fed is hiking in September."
Read MoreThe Street wanted more from Yellen