NEW YORK (Reuters) - A long-predicted dollar rally appears at last to be taking hold, with the greenback ending July with its best monthly performance in 17 months and investors positioning for the first post-crisis U.S. interest rate increase.
The Federal Reserve this week upgraded its assessment of the U.S. economy, which grew at a 4 percent annual rate in the second quarter. That effectively endorsed a view that the world's largest economy is probably months away from the Fed lifting interest rates from zero.
Rate futures markets expect the Fed to start a tightening cycle no later than next June and possibly earlier, a prospect that is dollar-positive given that central banks of most other developed economies remain in easy-money mode.
"As long as the U.S. economy continues to recover, I don't see why the undervalued dollar should not experience a broad-based recovery that I had expected at the start of the year," said Stephen Jen, a partner at London-based investment company SLJ Macro Partners.
Jen was not alone in predicting a dollar rebound at the beginning of the year, especially after the Fed in December announced it would wind down its bond-buying stimulus. In fact, most strategists turned dollar bulls at the start of 2014.
The greenback's momentum took time to materialise after the U.S. economy sputtered in the first quarter, thanks in part to a gruelling winter.
But the dollar's price action over the last two days of July was particularly significant. After being mired in narrow ranges since early April, the dollar has broken out, gaining against almost every currency in both emerging and developed markets.
The greenback advanced more than 2 percent against a basket of currencies in July, its best monthly performance since February 2013.
U.S. aggregate bond inflows so far in 2014 have far exceeded levels for all of last year. This year's bond inflows totalled $93.8 billion (£55.56 billion), more than four times 2013's $20.9 billion, Lipper data show.
Thursday's big drop in U.S. stocks notwithstanding, U.S. equities continue to attract inflows, totalling $137.14 billion so far in 2014.
In contrast, euro zone flows have started to deteriorate.
European equities showed a net outflow of about $500 million in July, the first this year, according to Lipper data.
Meanwhile, the euro has been consistently net sold since May 8, data from BNY Mellon showed. That was when European Central Bank President Mario Draghi signalled willingness to use unconventional measures to stem the euro's strength and counter the deflationary pressures afflicting the region.
Speculative positioning also turned net long dollars soon after that Draghi speech and has been so the past 11 weeks.
The euro ended Thursday at an eighth-month low below the $1.34 mark, for its biggest monthly decline in nearly a year and a half.
"It has been the renewed dollar buying by real money investors this month that is pushing euro/dollar lower at present," said Samarjit Shankar, managing director and head of iFlow and quant strategies at BNY Mellon in Boston.
Yields on U.S. assets such as Treasuries are also more attractive than other developed economy bonds.
The U.S. 10-year Treasury yield of around 2.55 percent is about 1.39 percentage points higher than comparable German Bunds. The difference between the two is the widest in more than 15 years.
Some investors believe the dollar's recent strength may not last.
Jonathan Lewis, chief investment officer at Samson Capital Advisors in New York, said a still-fragile U.S. housing sector could challenge the dollar's uptrend.
"The rate-sensitive housing market was the epicentre of the financial crisis, and Fed tightening ... would simply be the wrong medicine," he said.
Lewis added that the dollar index is currently in the middle of a range that has held for nearly three years. "When the market focuses on the reality of a Fed on hold for a very long time, expect a move to the bottom of the range."
Still, a number of measures of short-term interest rate expectations suggest more tail winds for the dollar.
The U.S. 1-year, 1-year forward rate, or rate expectations 12 months from now, rose to a three-year high of 1.2 percent this week from only 0.45 percent last fall, according to Societe Generale data.
In 2004 the 1-year, 1-year forward rate spiked to more than 4 percent from 2.5 percent as the start of the Fed's last tightening cycle approached.
"We think this is the start of the move higher in Fed expectations because we believe the U.S. economy is moving on to a firmer growth outlook, taking the dollar along with it," said Alvin Tan, senior currency strategist at Societe Generale in London.
Reporting by Gertrude Chavez-Dreyfuss; Editing by Dan Burns and Dan Grebler