The US dollar rallied to a 13-month high as a major slide in the Japanese yen further strengthened the greenback's outlook ahead of widely expected Federal Reserve rate hikes.

The Japanese yen slid to its lowest level against the US dollar since 1986 early Tuesday morning, crossing the previous post-1986 high-water mark of 161.95. That has supported the dollar, which traded just under its 13-month high of 101.80 initially reached on Wednesday.

The US Dollar Index (DX-Y.NYB), which measures the performance of the greenback against a basket of other currencies, has now returned 3.1% year to date, with roughly two-thirds of that rally occurring in the past month as the yen slid and rate-hike bets increased.

Even after the Bank of Japan raised rates earlier in June to 1% from 0.75%, Japanese target rates remain far below those of other developed nations, prompting investors to sell yen in exchange for currencies such as the US dollar in search of a better return.

At the same time, bets on a Federal Reserve interest rate hike are providing a further boost to the greenback.

During Kevin Warsh's first meeting as Federal Reserve chairman earlier this month, the Fed voted to hold the US target rate steady at a range of 3.5% to 3.75%, as widely expected. Looking forward, however, traders have fully priced in at least one rate hike from the Fed by the end of the year, with nearly two-thirds odds of a second to come by March, per Bloomberg data.

Driving those bets has been a months-long trend of inflation figures coming in above expectations and remaining stubbornly above the Fed's target rate of 2%. The Federal Reserve's preferred inflation gauge, the Personal Consumption Expenditures (PCE) index, showed prices heated up further in May in data released last week, with "core" inflation hitting its highest level since October 2023.

Higher interest rates tend to strengthen the dollar because they increase the returns investors can earn on dollar-denominated assets such as Treasury bonds, attracting foreign capital. As demand for those assets rises, so does demand for dollars, which can push the currency higher relative to others.

The dollar has also been supported by a third leg, according to Goldman Sachs strategist Lexi Kanter: the artificial intelligence boom. As the AI industry has sent the US tech sector soaring, foreign investors have scrambled to buy US equities, driving up the dollar as investors exchange foreign currencies for dollars to buy American stocks.

"If anything, the Dollar has appeared slightly weaker than expected from this perspective alone," Kanter wrote to clients.