US dollar breakout lacks conviction

Summary:

• US dollar likely to wait for more clues from the FOMC next week
• Support at 95.50 – 95.75 likely to be tested ahead of further upside
• FOMC, BoJ will be the key events to watch next week
• Market outlook on the US dollar turns bullish with the probability of a Fed rate hike increasing for December

The US dollar touched a 4-month high this week trading at 97.36 on Wednesday. The gains came as the US dollar finally managed to breakout from the bullish flag pattern that was formed following the consolidation above 95.75 – 96.0 support level. Supported by economic data this week, the US dollar edged higher. Still, most of the data this week concentrated on the US housing markets. Building permits gained 1.50% while housing starts rose 4.80% in June. Existing home sales also inched higher, rising 1.10%, all of which beat conservative estimates.

The optimistic economic data brought back speculation of US Fed rate hikes. As the FOMC meeting kicks off next week on July 26 – 27, market participants are starting to price in a Fed rate hike at the December meeting. The CME Futures Fed funds watch tool showed that the probability of a 25bps rate hike in December jumped to 40.0%. It was not long ago that after the disappointing May payrolls report, the probability for a rate hike in 2016 remained near zero.

The Federal Reserve is expected to stay on the sidelines next week but could potentially prepare the markets for a rate hike in September, if the economic data continues to support the case. The bullish view for the Fed is in stark contrast to most of the other central banks. This week, the ECB and last week the BoE signaled no changes to monetary policy. But the Bank of England noted that it could ease policy as early as the August MPC meeting. While ECB’s Mario Draghi signaled that the central bank needs more time to assess the situation so far. Next week, speculation runs high that the Bank of Japan could unleash as much as 20 trillion yen in addition to its 80 trillion yen in monetary base. A follow through from the BoJ could indirectly help the US dollar to push higher, while weakening the yen.

US dollar index – Technical outlook

Following the breakout from the bullish flag, the US dollar index broke above the previously established high of 96.55, bouncing off the 95.95 support. This small rally saw prices run up to post a 4-month high at 97.36 this week before pulling back lower. The dollar index closed yesterday at 96.91. Unless price action can breakout above the recently established higher, the US dollar could remain range bound into next week’s FOMC announcement, which if hawkish could support the dollar to the upside.

However, we expect that the dollar index is likely to pullback in the near term with the potential to test the 95.50 – 95.75 level of support before pushing higher. This view is seen on the weekly chart, where prices are currently trading within a minor rising wedge pattern and support is seen at 95.75 – 95.50 which is yet to be properly tested. A pullback to this support will establish the required support level which could then see the US dollar index move higher, potentially targeting 98.50.