U.S. Dollar Rally Isn't All It Seems

An index that tracks the U.S. dollar’s performance soared this week to a seven-month high. But the recent rally isn’t all it appears to be.

That’s because the biggest driver of the dollar's strength has been the near collapse of the British pound.

The WSJ Dollar Index, which measures the value of the greenback against 16 other currencies, has climbed about 2% this month, touching its highest levels since mid-March. But roughly a third of that move through Wednesday is attributable to a sharp drop in the British pound, according to the WSJ Market Data Group. Sterling, which has fallen about 6% this month, has an 11% weighting in the index.

Sterling has sold off this month on concerns about the impact of Britain's decision to leave the European Union in a so-called hard Brexit. Many expect that U.K. Prime Minister Theresa May will push for a separate trade agreement and make controlling immigration a top priority.

Federal Reserve officials are unlikely to see this recent pound-driven dollar rally as a reason to put off raising interest rates.

Fed-funds futures, a popular tool for betting on central-bank policy, showed Friday that investors assigned a 66% likelihood of a rate increase in December, according to CME Group data. That's up from about 50% a month ago.

Fed officials previously have cited the stronger dollar as a reason to not raise interest rates, but their concerns appeared centered on how the currency was tightening financial conditions for emerging market countries.

"If you had a sharp rise in the dollar, a sharp fall in equity markets, a sharp widening in credit spreads, the Fed would find that relatively difficult," said Paul Lambert, head of currency at Insight Investment. "I don't think it is at this point."

Mr. Lambert has added to bullish bets on the dollar lately. The U.S. currency typically strengthens when expectations for Fed interest-rate increases rise, as dollar assets become more attractive to yield-seeking investors.

"We are mindful of possible spillovers to other economies, including emerging market and developing economies." said Stanley Fischer Vice Chairman in a June 2015 speech, warning that higher U.S. rates "could cause investors to adjust their portfolios, triggering capital outflows from emerging market and developing economies."

A stronger greenback weakens developing markets' currencies and makes their dollar-denominated debts more expensive to pay back. China is seen as particularly vulnerable to higher U.S. rates. It also hurts U.S. multinationals by making their products more expensive overseas.

The dollar’s strength was a factor in the February market panic, when concerns about U.S. corporate earnings, oil prices, and a slowdown in China led to a rout in global markets.

In a June speech, Fed Governor Lael Brainard warned: "Should exchange rate pressures reemerge, we cannot rule out a recurrence of financial stress.”

Despite its recent strength, the WSJ Dollar Index remains around 3.5% below the highs reached at the beginning of the year. What's more, nearly 80% WSJ Dollar index's gains this month have been a result of a fall in the pound, euro, and Japanese yen. Weakness in emerging-market currencies has contributed just 6% to the index's gains through Wednesday.

As expectations for higher U.S. rates have climbed this month, signs of stress in emerging-market currencies have been muted. The Russian ruble is down about 0.3% this month, while the Taiwan dollar has fallen about 1.5% against the dollar. The Chinese yuan has fallen to a six-year low versus the dollar, but the currency has gained against a basket of major trading partners tracked by Thomson Reuters.

Both the Brazilian real and Mexican peso are up about 2% versus the dollar.

"Any sort of whiff of tightening does send a bit of a shock wave to emerging-markets," said Win Thin, head of emerging-market currency strategy at Brown Brothers Harriman. "The good news is that there is some kind of decoupling. It's not buy or sell everything in emerging-markets."

Mr. Thin said if the Fed raises rates in December, "there would be some pressure, but it depends on the message they send." Many analysts are expecting a "dovish" December rate increase, where the Fed raises borrowing costs but signals that there will be fewer rate-increases in the future.

That would likely constrain the dollar's rise and ease pressure on emerging-markets.