THE DOLLAR RISES ABOVE THE FRAY / THE WALL STREET JOURNAL

Heard on the Street

The Dollar Rises Above the Fray

Several factors point to a stronger dollar, with mixed implications for stock-market investors

By Justin Lahart

Aug. 29, 2014 12:17 p.m. ET

Change is coming to the U.S. dollar.

The dollar has been anything but mighty over the past decade. Federal Reserve figures show that on a trade-weighted basis, the greenback has fallen more than 10% against other major currencies in that time.

Lately, though, it is showing a bit more vigor. The dollar has strengthened against the euro, yen and pound this month, building on a move higher in July. It marked the first time it has made back-to-back monthly gains against all three currencies since 2008. And there may be more to come.

Judging exactly what determines exchange rates at any given time is more than a challenge. Differences in countries' economic growth profiles and relative price levels play a role. Trade flows are also important. So, too, are interest rates. The mystery of how these and other variables, such as the dollar's reserve currency status, interact probably won't ever be cracked completely.

But what is interesting now is how many foreign-exchange drivers seem to be pushing in the dollar's direction.

The U.S. economy, while hardly gangbusters, has been expanding at a much faster clip than that of either Japan or the euro zone. And with both hiring and business spending picking up, U.S. outperformance looks likely to continue.

That should mean better returns on investment and more reason for companies and investors to put their money to work stateside. Prices run in the same direction, with figures from the Organization for Economic Cooperation and Development showing a dollar spent in the U.S. buying about 10% more than it would after being exchanged for the euro in Germany or the yen in Japan.

The current-account deficit, the broadest measure of the U.S. trade gap, has narrowed to 2.7% of gross domestic product from the record 6.2% it hit in 2005. With the U.S. becoming progressively less dependent on foreign oil, the deficit is on course to narrow further still. That lessens the old fear that other countries might call in America's IOUs, sending the dollar lower.

Finally, interest rates favor the dollar. The 2.33% yield on the 10-year Treasury note is higher than equivalent yields in the U.K., any of the major European countries, Canada or Japan. With the Fed poised to begin lifting its overnight target rate next year, even as the Bank of Japan 8301.TO in Your Value Your Change Short position is keeping its foot to the floor and the European Central Bank hints at quantitative easing, rate differentials may only widen. That sets up a carry trade, in which investors can generate returns by lending in the U.S. with funds borrowed abroad.

For investors, a firmer dollar would present a mixed bag. The many U.S. companies that have aggressively expanded their overseas operations in recent years could see currency-related hits to earnings.

Against this, there is the intuitive, but often overlooked, fact that a stronger dollar makes the cash investors hold worth more.

More important, by lowering the cost of imported goods, a stronger dollar would also help keep inflation in check. That would, in turn, offer some protection against any risk that the Fed ends up having to raise interest rates sharply to cool an overheating economy.

Given the centrality of the central bank's next steps in moving the market, this may be the most far-reaching impact of a dearer dollar.