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Matt Day and
Anjani Trivedi
Updated Sept. 2, 2014 6:44 p.m. ET

Shifting approaches by central banks around the world are causing new gyrations in currency markets.

As the Federal Reserve gets closer to raising rates, and European and Japanese central banks move toward possible further loosening of monetary policies, the dollar is gaining ground against the euro and the yen.

The WSJ Dollar Index, a gauge of the dollar's exchange rate against seven of the world's most heavily traded currencies, is up 3.4% in the past two months, after barely budging in the first half of the year. On Tuesday, it rose 0.4% to its highest level since July 2013, as a report showed U.S. manufacturing activity in August accelerating at the fastest pace in more than three years.

Meanwhile, the latest readings on the eurozone and Japanese economies have been disappointing, leading many investors to expect central banks in these regions to roll out more easy-money policies.

Many fund managers say this week they are likely to see more evidence the U.S. economy is diverging from those of Europe and parts of Asia, a trend that could propel the dollar further.

Many investors expect the Fed to raise rates sometime next year. A rate increase by the Fed would attract cash from around the world to the U.S., lifting demand for the dollar and its value. Even though economists say the dollar hasn't risen enough yet to pose a threat to the U.S. recovery, a stronger currency could create headwinds for the economy. A rising greenback would make exports less competitive, becoming a drag on growth.

The Labor Department's closely watched monthly jobs report, set for release Friday, is expected to show hiring picked up in August. A day earlier, the European Central Bank is to meet, and market watchers expect officials to further detail the bank's plans to start asset purchases to stimulate economic activity. Reports released Monday showed growth in manufacturing slowed sharply last month in the U.K. and the eurozone.

"The U.S. is humming along," said Gary Herbert, a portfolio manager with Brandywine Global Investment Management, which oversees $58 billion in assets. "The rest of the world hasn't been following suit—Europe and Japan in particular."

Mr. Herbert said he has been buying dollar-denominated bonds in the past few months, and that the firm's broad debt portfolios didn't hold any exposure to the euro or yen. Photo illustration: Reuters

While many investors have expected a broad move higher in the dollar for months, if not years, past rallies have been thwarted by patchy U.S. indicators. Uneven economic signals and uncertainty about the timing of any central-bank moves have kept currency markets placid until recently, frustrating investors betting on a pronounced drop in the euro against the dollar.

In recent weeks, the disparity between relatively healthy U.S. economic data and disappointing reports out of Europe and Japan has become too large for some investors to ignore.

In the aggregate, the number of bets on the dollar rising against the euro and the yen rose to a record 253,548 contracts as of Aug. 26, according to the latest U.S. Commodity Futures Trading Commission data. That is more than double the figure at the start of the year.

Despite the recent rally, the dollar remains well below its highs of the early 2000s. And there are some doubts the Fed will move as fast as bullish investors expect, given that growth in some corners of the U.S. economy remains fragile. That could undercut the rally, some skeptics say.

The dollar "is not cheap anymore," said Sam Katzman, chief investment officer with Constellation Wealth Advisors, which oversees about $6 billion. Some U.S. companies have benefited from a relatively weak dollar in recent years, Mr. Katzman said, a trend that could reverse if the dollar's strength lasts. And with the U.S. stock market at record highs, investors could become reluctant to put more money in stocks, tempering the dollar rally, he added. "When you have a stock market that's not cheap, and you get some currency headwinds going against you," stock investors and companies alike may consider shifting U.S. assets abroad, Mr. Katzman said.

The euro fell to an 11-month low of $1.311 Tuesday before rebounding to trade near unchanged at $1.313. The Japanese yen also slumped, hitting a seven-month low and trading at ¥105.09.

Christopher Brandon, founding partner of Rhicon Currency Management in Singapore, said currency markets will likely start to react more strongly to coming economic-data releases as investors anticipate what the data would mean for monetary policy.

"This should all create more volatility as we break out of the unbelievable complacency" that has characterized markets in the past year, Mr. Brandon said.

Fed officials signaled late last month that growth was robust enough to end the central bank's bond-buying program, implemented after the 2008 financial crisis to stimulate the economy, in October. Many fund managers see that step as a precursor to raising benchmark interest rates. The odds of a rate increase at the Fed's June 2015 meeting were 49% Tuesday, according to data from CME Group based on prices of 30-day fed-funds futures, a derivative instrument traders and investors use to wager on the timing of rate increases.

—Min Zeng contributed to this article.

Write to Matt Day at email@example.com and Anjani Trivedi at firstname.lastname@example.org





