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An October surge in the U.S. dollar is reawakening concerns over financial markets' vulnerability to a likely Federal Reserve rate increase.

The WSJ Dollar index rose for the eighth time in the past 10 trading days, hitting a high last seen in the spring. It has risen 2.4% this month. China set the value of the yuan at a six-year low Wednesday, while currencies in major emerging markets such as Brazil, Russia, Mexico declined against the dollar.

The dollar's strengthening has been accompanied by an increase in long-term bond yields, reflecting wagers that the Fed will raise rates as soon as December, and an autumn recovery in market inflation expectations fueled by oil-price gains. On Wednesday, the 10-year U.S. Treasury yield rose by about 0.02 percentage point to 1.778%, its highest close since early June, while Nymex crude closed above $50 for a third consecutive day.

The increases in the dollar and U.S. bond yields so far have been modest, while the prices of riskier assets such as stocks have been largely unaffected. The Dow Jones Industrial Average on Wednesday rose 15.54 points to 18144.20.

But many investors say that continued rises in the dollar and bond yields could complicate the Fed's plans to raise interest rates this year for the second time since the financial crisis, by potentially spurring renewed capital outflows from emerging markets.

"Clearly a significant tightening of financial conditions with a strong dollar rally and higher bond yields would be of concern for the Fed," said Gemma Wright-Casparius, senior portfolio manager of the fixed-income group at the Vanguard Group.

A stronger dollar is generally good for the U.S. economy, boosting the purchasing power of consumers and businesses while holding down inflation.

But a rising dollar also stands to hit U.S. corporate earnings at a time when they already are under pressure and stock valuations are broadly seen as stretched. It also threatens to hamstring policy makers' efforts to generate modest inflation gains.

"This Fed is more market dependent than data dependent," said Donald Ellenberger, head of multisector strategies at asset-management firm Federated Investors. If stocks drop significantly prior to the December meeting, he said, "the Fed is very unlikely to raise rates."

Fed officials meeting in September laid the groundwork to raise short-term interest rates "relatively soon," according to minutes of the meeting released Wednesday afternoon, although the officials struggled to reconcile internal divisions over the timing of the next rate move.

Federal-fund futures on Wednesday reflected a 70% probability of a rate increase by the Fed's meeting in December, according to data from CME Group. The odds were around 50% a month ago and nearly zero soon after the Brexit vote.

Eurodollar futures showed the value of net bets wagering on higher interest rates in the U.S. hit a two-year high of $1.255 trillion for the week ended Oct. 4, according to data from TD Securities.

Rising-rate expectations are pushing government-bond yields in the developed world higher after a sharp midyear decline.

The yield on the 10-year German bund yield has risen back above zero again this month, while the 10-year U.K. gilt yield topped 1% Wednesday.

Some analysts say the Fed should welcome the rise in bond yields because it reflects higher confidence among investors over the growth and inflation outlook.

As a result, some investors are selling Treasury bonds and buying Treasury inflation-protected securities in a bid to hedge inflation risks that are perceived to be on the upswing.

The so-called 10-year break-even rate, the yield spread between the 10-year Treasury note and the 10-year Treasury inflation-protected security, was 1.65 percentage point late Wednesday, a five-month high, according to Tradeweb. The figure suggests investors expect annual U.S. inflation of 1.65% in the next 10 years.

To be sure, few believe inflation is making significant inroads at the moment. The Fed's favored inflation measure has been below the central bank's targets for more than four years. Skeptics point to continuing challenges, such as rising debt and slowing growth in China.

The People's Bank of China set the daily midpoint for the dollar-yuan pair at 6.7258 on Wednesday, marking a 0.24% decline in the yuan from Tuesday's midpoint. Wednesday's fixing put the yuan at its lowest level against the dollar since September 2010.

The prospect of slowing growth has been driving money moving out of China and causing the value of the Chinese yuan to weaken. Analysts say China is unlikely to allow disorderly depreciation in the yuan, and that the People's Bank of China is going to intervene on signs of chaotic yuan moves.

Eric Stein, co-director of global income at asset management firm Eaton Vance Management, said markets "seem far less sensitive" to the yuan's weakness this time than they were in the market declines of August 2015 and January 2016.

"I don't think a weaker yuan per se will stop the Fed in its tracks," he said. "But if financial conditions broadly tighten, that could stop the Fed from hiking or least force them" to emphasize they don't expect long-term rates to rise sharply.

Saumya Vaishampayan contributed to this article.

Write to Min Zeng at min.zeng@wsj.com

(END) Dow Jones Newswires

October 12, 2016 22:55 ET (02:55 GMT)

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