LONDON (Reuters) - As speculation about interest rate rises and policy ‘normalization’ in the euro zone, Japan, Britain and China falls away rapidly, the U.S. Federal Reserve’s now lonely monetary tightening has suddenly supercharged the dollar.

FILE PHOTO: The Federal Reserve headquarters in Washington September 16 2015. REUTERS/Kevin Lamarque/File Photo

The revival of the U.S. currency after more than a year on the wane is already causing mayhem in emerging markets from Turkey to Argentina and Indonesia, while tightening global financial conditions in a way that could eventually make even the Fed consider a pause for thought.

In just two weeks the dollar has surged nearly four percent against a basket of the most traded currencies, erasing all the losses it had suffered since the start of 2018 .DXY.

Against a broader group of currencies, including those from emerging markets, the greenback is now in positive territory against half of them.

Two factors may indicate the dollar's rise, which is potentially damaging to the world economy due to its pre-eminence as a global funding currency, has more room to run. (U.S. yield differentials support dollar: reut.rs/2IeomUK)

First is the interest rate gap. While the Fed left interest rates unchanged on Wednesday, it is possibly set to raise them by a total of 75 basis points this year. This means U.S. rates are likely to pull still further ahead of all others in the developed world.(U.S., China surprise to the upside: reut.rs/2IaK3Fe)

The Fed’s overnight lending rate in already in a target range of 1.50-1.75 percent compared with the European Central Bank’s closely watched deposit rate benchmark at minus 0.4 percent while the Bank of Japan pledges to guide short-term interest rates at minus 0.1 percent.

Data on Thursday showing euro zone inflation slowing further last month could cement that view, especially after the Fed showed no sign of swerving from its tightening path after its policy meeting, calling recent U.S. inflation rises sustainable. (2018: Return of King Dollar?: reut.rs/2Ieod3E)(2017: Dollar in the dumps: reut.rs/2recuIQ)

The second factor is the record overhang of “short” dollar bets by speculators who believed the greenback would weaken. These amounted to nearly $24 billion as of end-April, as seen by positioning data, just off a $28 billion peak.

Such bets had multiplied by a factor of 10 in slightly more than a year based on a belief that other major economies, notably in Europe, would continue expanding at a faster pace than the United States, allowing central bankers to react faster than what markets were pricing in.

"The link-up in the yield differential and the dollar theme means the rally may have further room to run, especially against the euro and sterling as there is a big structural short dollar position in the market," said Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers.(US financial conditions: reut.rs/2JQ5GrH)

Anecdotal evidence suggests short dollar bets may be far bigger, thanks to a slow moving allocation away from the greenback in recent years among large institutional investors.

The dollar’s rally this year is quite a turnaround from 2017 when it weakened against every other currency.

Even in early 2018, most analysts were tipping greenback losses to escalate. The euro was on a roll, with the ECB looking set to roll back its economic stimulus in September and raise rates in the first quarter of 2019.(Last man standing: reut.rs/2rifa8m)

Similarly, sterling seemed to have left behind its Brexit-related worries due to expectations of two interest rate rises this year by the Bank of England. Likewise, the Japanese economy had enjoyed eight straight quarters of expansion, the longest such run since the 1980s.

But a string of ominously weak data is causing speculation that the ECB may have to delay closing its bond buying program from September. Such data appears to have also scuppered a May rate rise in Britain while Japan ditched on April 27 its timeframe for hitting inflation targets, indicating no let-up in its stimulus.

“Expectations for European and Japanese growth probably went too far, and we have seen a bit of loss of momentum,” said Nick Wall, a portfolio manager at Old Mutual Global Investors, though he noted growth still remained robust in these regions.

China’s central bank meanwhile has also contributed to dollar strength via liquidity injections into money markets and by cutting reserve requirement ratios for banks by 100 basis points in mid-April.

“The addition of liquidity suggests to markets that the Chinese yuan trade-weighted index appreciation trend was set to pause, in turn suggesting implicit dollar strength,” Morgan Stanley analysts told clients.

Some other central banks, notably those in Switzerland and Sweden, have also turned more dovish, with the latter suggesting this week that more “tools” may be deployed to lift inflation.

“That indeed leaves the Fed as the only tightening game in town,” Wall said.

The policy divergence is shown in bond markets where spreads between German yields and equivalent U.S. debt has blown out to its widest in three decades at 240 basis points. Similarly, the UK/U.S. yield gap widened this week to the most since 1984.

Many people, including Wall, still see the dollar failing to extend its recent surge, given the United States needs a weaker currency to fix its deficit and the Fed’s awareness of the knock-on effects on developing countries of a rampant dollar.

But dollar appreciation could also feed more gains, should it persuade overseas investors to buy U.S. debt without hedging currency exposure. Asian funds have balked at buying Treasuries in recent months as higher U.S. rates raise hedging costs.

That shift to unhedged buying, a dramatic move for bond investors, could lead to more dollar purchases, Lombard Odier’s Ahmed said.