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Dollar Rally Is Biggest Since January as Fed Stokes Divergence

The dollar extended its biggest advance since January to a third week as traders weighed the possibility of tighter monetary policy in the U.S. against stimulus in Japan and other major economies.

The U.S. currency has rallied since the minutes of the Feds most recent meeting prompted traders to add to bets on a June rate hike. The move was also spurred by Bank of Japan Governor Haruhiko Kuroda reiterating that hes ready to add to stimulus if necessary. Japan used a meeting of finance chiefs from the worlds major industrialized nations to warn of the economic risks from sharp swings in the yen, even as the U.S. made clear that currency markets remain calm.

The greenback surged for the past three weeks in its longest run of gains since January as traders renewed expectations for the U.S. central bank to raise borrowing costs. The currencys rebound snapped three months of losses, during which markets questioned the Feds ability to tighten monetary policy amid a softening global growth outlook.

The definition of divergence has really changed, said Steven Englander, New York-based global head of Group-of-10 currency strategy at Citigroup Inc., the worlds biggest currency trader. Last year, we thought divergence was four hikes a year for the Fed, now its like two hikes, maybe, he said in an interview on Bloomberg Television. He expects the dollar to strengthen when the Fed raises rates.

The Bloomberg Dollar Spot Index, which tracks the U.S. currency versus 10 major counterparts, gained 0.8 percent this week as of 5 p.m. in New York, adding to the 2.3 percent advance in the past two weeks. The dollar rose 0.2 percent to 110.15 yen Friday and slipped 0.2 percent to $1.1224 per euro.

The yield premium offered by two-year U.S. Treasury notes over equivalent Japanese government bonds surged to the highest since the 2008 financial crisis.

Hedge funds and other large speculators reduced bets against the dollar to a net 10,653 in the week ending May 17, according to data from the Commodity Futures Trading Commission show. Investors turned bearish on the greenback for the first time since 2014 last month.

Fed Policy

We saw a very big shift in the markets view on Fed policy following comments from U.S. officials and the surprisingly hawkish minutes, said Ulrich Leuchtmann, head of currency strategy at Commerzbank AG in Frankfurt. So far, the Federal Open Market Committee tended to interpret data cautiously. Now they seem to interpret them optimistically. Thats the big shift.

Against this backdrop, any positive U.S. data would have a strong impact on dollar rates, more than usual in the recent past, Leuchtmann said.

Theres a 26 percent chance the U.S. central bank will raise rates at its June meeting, up from just 4 percent on Monday, based on fed fund futures compiled by Bloomberg. The odds for a July move rose to 48 percent from 19 percent.

The dollar also rose after New York Fed President William Dudley said Thursday that June is a live meeting for the central bank, and Richmond Fed President Jeffrey Lacker said the case for hiking rates would be very strong.

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