EUR/USD Outlook: Can Hot CPI Sustain the Stretched US Dollar Rally?

The US dollar rally is showing signs of exhaustion ahead of US CPI, despite expectations for a sharp rise in inflation. With EUR/USD oversold, bearish momentum fading and higher inflation potentially priced in, even a modest CPI disappointment could trigger a dollar pullback and provide the euro with some relief.

EUR/USD Eyes Rebound as US Dollar Rally Faces an Inflation Test

US inflation data drops in a few hours, and it could help set the tone for Kevin Warsh’s comments at his fireside chat on Friday. It is no secret that crude oil prices are likely to see inflation heat up, given they rallied as much as 60% from the July low to September high, and are now curling higher once more and heading towards $100.

Naturally, this has prompted consensus forecasts to rise to 0.6% in September, or 2.5% annualised. For perspective, that would be the third-highest monthly print in four years and the second-highest annual rate in three.

US Dollar Faces Pullback Risk as Inflation Expectations Look Priced In

But we know that energy prices are likely to be a major driver. Therefore, the two questions are how broad-based the inflationary pressures are, and whether higher inflation expectations have already been priced in?

We can see that Brent crude prices have accelerated, making them a useful leading indicator of energy-related inflation pressures. We’ve already heard the RBA express concern that inflation could become more broadly based than just energy, and if such evidence shows up in today's US figures, it will likely exacerbate those concerns for central banks in general. Moreover, it could revive hawkish Fed bets.

That said, I have a hunch we’re not going to see that just yet. Core inflation has been relatively contained, while shelter inflation continues to ease. And that leaves today’s CPI with the potential to dent the USD, despite consensus forecasts having risen.

US Dollar Rally Looks Stretched Ahead of CPI

The US dollar index has rallied just under 4% over the past five weeks, and price action suggests trend exhaustion could be kicking in around major resistance levels. With traders already expecting higher inflation, there’s a decent chance it is already priced in – and anything less than expected, even if only marginally, could prompt a pullback in the dollar.

US Dollar Index (DXY) weekly and daily charts showing resistance near 102, bearish RSI divergences and slowing bullish momentum ahead of US CPI.

Source: ICE, TradingView

EUR/USD and USD/CAD Implied Volatility Spikes Ahead of US CPI

Looking across FX majors shows that 1-day implied volatility has spiked for USD/CAD and EUR/USD. I outlined a near-term bearish case for USD/CAD in an earlier report, based on its extended rally, pause around resistance levels and bearish engulfing candle on Tuesday. Its 1-day IV is 84 pips, which is 167% of its 20-day average.

Yet EUR/USD has gone a step further with a 1-day IV of 90 pips, or 237% of its own 20-day average. Expected levels of volatility are also elevated on USD/CHF, GBP/USD, AUD/USD and NZD/USD, though only marginally above their own 20-day averages.

EUR/USD Technical Analysis: Euro vs US Dollar

If the US dollar rally appears stretched, there is a reasonable chance the EUR/USD rally could be oversold – given the euro accounts for nearly 60% of the DXY weighing. The weekly chart shows that its 4-week decline is losing bearish momentum with diminishing high-to-low ranges (bottom indicator). The weekly RSI (2) has been oversold for several weeks and now trying to curl higher, while a bullish divergence has formed on the daily RSI’s. Moreover, the 50-day detrended price oscillator (DPO – bottom indicator) is near levels previously associated with trend reversals. This is not an exact science as such indicator provide ‘indications’ and not signals as such. But put together, bears may at least want to tread with caution.

Also take note of Tuesday’s bullish engulfing candle. With a hunch that a hot CPI is priced in and high crude oil prices might not be showing up much beyond energy, my bias is for a bounce on EUR/USD while prices hold above the recent swing low.

Source: ICE, TradingView