(Big Stock)

The dollar has hit a 12-year high against the euro, and it's not going to stop anytime soon. Not when the dollar is in the middle of its biggest rally in almost 40 years.

But it's not just the euro that the dollar is rising against. It's pretty much every currency in the world. That's because the U.S. economy is doing well enough that the Federal Reserve is getting ready to raise rates, and the rest of the world is slowing down enough that it's cutting them. And that's not hyperbole. The not-so-short list of countries that have eased monetary policy the past few months includes Australia, Canada, Chile, China, Denmark, Egypt, India, Indonesia, Israel, Peru, Poland, Russia, Singapore, South Korea, Sweden, Switzerland, Thailand, Turkey, and, above all, the eurozone now that it's buying bonds with newly-printed money—aka quantitative easing—which Japan has also been, and still is, doing itself. The result is that investors can get better returns in the U.S. than they can in a lot of other places—would you rather buy a U.S. 10-year bond that pays 2.05 percent or a German one that pays 0.28 percent?—so that's where they're moving their money, and, in the process, pushing up the value of the dollar.

That's actually an understatement. The dollar is exploding up more than it's getting pushed up. As Citibank's Steve Englander points out, the dollar, going by its trade-weighted exchange rate, has increased more in percent terms the past 175 trading days than it has in any other similar period going back to 1976. And that will only continue if the Fed really does raise rates in June. It's expected to take the first step towards doing that by saying it will no longer be "patient"—Fedspeak for waiting at least two months—about hiking rates at its next meeting on Wednesday.

But wait a minute. If the Fed has told us it might raise rates, and told us that again, and again, and again, why would the dollar go up that much if it does does raise rates like it's said? You don't have to believe in perfectly efficient markets—only non-inefficient ones—to think that some of this should be priced in already. Well, the answer is that markets don't believe the Fed. Investors used to think there was an almost 50 percent chance the Fed would start raising rates in June, but then inflation fell and, as you can see below, those odds did too, down to just 18 percent today. Even normal-ish unemployment hasn't been enough to convince them that the Fed will begin normalizing policy—not when core inflation is so far below target.


Source: Bloomberg

Now it's true that more investors are starting to listen to the Fed and bet on a June rate hike. But despite that, markets would still be caught pretty off guard if the Fed's lack of "patience" turns into higher interest rates so soon. The dollar would shoot up even more violently, and put even more of a crimp in the recovery by making it harder for U.S. companies to sell exports overseas and compete against imports at home. But why would one teeny tiny rate hike matter that much? Well, because it's not just one teeny tiny rate hike. Earlier liftoff tells us that what economists call the Fed's reaction function is more hawkish than we thought. In other words, if the Fed raises rates sooner than we think they should today, they might raise rates more than we think they should later.

The only question is how much more the dollar is going to go up: a historic amount or something slightly less than that.

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