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This is 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 is pushing 124, a key level not seen since June 2007.
"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.
Dollar-yen is currently at an eight-year high, and Schlossberg said the 124 level is a big round number the whole market is watching. If it gets there, 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.
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Short-end 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.
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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.
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