EUR/USD, USD/CHF Outlook: The Fed may amplify dollar downside risks

• Lower oil takes heat out of the dollar
• Fed dots may disappoint the hawks
• AI may support growth without inflation
• EUR/USD and USD/CHF reversals may have further to run

Lower oil, lower yields, softer dollar

The balance of risks may be shifting towards further EUR/USD upside and USD/CHF downside, and not just because of progress in peace negotiations between the US and Iran ahead of a signing ceremony slated for Friday.

The easing in perceived supply risks has seen investors rapidly unwind the geopolitical premium embedded in energy markets, sending Brent crude sharply lower from recent highs. That, in turn, has helped alleviate concerns about the inflationary consequences of higher oil prices, weighing on US Treasury yields and taking some of the heat out of the greenback.

Source: TradingView

Should this trend continue, which seems likely for now given both sides continue to make all the right noises on the peace front, the reversals in EUR/USD and USD/CHF may still have further to run in the near term.

The dots versus the curve

However, while energy prices may help explain the latest bout of dollar weakness, whether it extends from here may ultimately depend on the Fed.

The Fed funds curve out to June 2027 still has 27.5 basis points of hikes priced, as shown in the chart below. That's a very different profile to the last median dot plot estimate published in the Fed's March Summary of Economic Projections, which pointed to two 25 basis point cuts from where the funds rate currently stands by the end of 2027.

Source: TradingView

What markets may be underestimating is the influence continued AI adoption could have on productivity, growth, inflation and, ultimately, the Fed funds rate outlook.

Yes, the AI infrastructure rollout is undoubtedly inflationary in some energy and electrical categories in the near term, but that's hardly a new development. The more important question is whether the productivity gains it eventually delivers allow the US economy to grow at a faster pace without generating the inflationary pressures that would ordinarily accompany such an outcome.

Newly appointed Fed chair Kevin Warsh has been vocal in arguing precisely that. While there's no guarantee the broader FOMC will fall in behind his view, the March Summary of Economic Projections suggests at least some members may already subscribe to a similar view. Despite the inflationary implications stemming from the war at the time, the median year-end growth projections were revised higher, suggesting at least some members believed the economy could continue to expand at a solid pace while unemployment remained low.

While the Fed will likely abandon its easing bias given remarks from influential FOMC members such as Governor Christopher Waller in the period since it last met, such an outcome is already widely expected by markets. As such, that's why the updated dot plot may struggle to come across as hawkish as markets currently have priced.

Even if the Committee signals a willingness to remain on hold for longer, it would be surprising to see the median participant suddenly conclude that neutral rates sit around the current fed funds rate of 3.50-3.75%. Back in March, the median dot still pointed to one cut this year and next, with the longer-run fed funds rate sitting at 3.1%.

Source: Federal Reserve

As the Fed's projections above show, modest easing beyond the near term may still prove the more likely outcome. If so, the 27.5 basis points of hikes currently priced into the fed funds curve out to June 2027 may need to be unwound, adding to the downside risks facing the dollar.

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The rates link

As seen in the correlation matrix below, there's been a strong and sustained inverse relationship between the amount of tightening priced by the Fed over the coming year and EUR/USD in recent weeks. The 20-day rolling correlation currently sits at -0.72, while the five-day measure has strengthened to an eye-catching -0.99, highlighting just how sensitive the pair has become to shifts in the US rates outlook.

Source: TradingView

In simple terms, as markets have unwound expectations for nearly two Fed hikes over the coming year, EUR/USD has rallied. While that largely reflects the easing in crude markets and the associated decline in US Treasury yields discussed earlier, it arguably doesn't capture the possibility that the Fed itself may struggle to come across as hawkish as markets expect later today.

Should that prove to be the case, it would provide another potential tailwind for EUR/USD alongside those already emanating from lower energy prices and an improving outlook for Europe.

EUR/USD: A formidable barrier looms

Source: TradingView

The technical picture for EUR/USD has turned more constructive for bulls over the past fortnight, with the pair rebounding from 1.1500 support to test the uptrend running from the lows set back in March. It previously acted as support within a broader compression structure prior to being broken, and the fact the price has now tried and failed on two separate occasions to close above it suggests it remains relevant for traders.

However, as the pair flirts with that level, the true test for bulls lies further overhead with an ominous resistance zone comprising each of the key medium and longer-term moving averages, the 38.2% Fibonacci retracement of the January-March bear move, along with 1.1670 which has offered both support and resistance for lengthy periods throughout much of this year. Throw in downtrend resistance from the former compression structure and it looms as a significant barrier for upside, meaning that even if my theory regarding the Fed rate outlook proves correct, it's no guarantee it will deliver immediate, substantial gains.

However, if the price were to break above the top of the zone at 1.1677, it would break the sequence of lower highs, adding to the risk we may see a run towards 1.1750 or 1.1850 resistance.

Like recent price action, the message from the oscillators has also shifted. Not long ago, downside momentum was building, but that's now completely fallen away. RSI (14) is trending higher and is now back at the neutral 50 level, while MACD has just staged a crossover of the signal line and is diverging towards positive territory. It's not a slam-dunk case for bulls, but it suggests directional risks are now far more balanced than they were just a week or so ago.

Should the latest corrective bounce stall around these levels, the 23.6% Fibonacci retracement of the January-March bear move at 1.1570 should be on the radar, along with where it began at 1.1500 support.

Fed, not SNB

Like the message from the EUR/USD matrix, the Fed interest rate story is also highly relevant to USD/CHF traders given the similarities across continental Europe, with that far more likely to move the dial than the Swiss National Bank's rate decision on Thursday.

No change in policy is expected from the SNB, and unlike earlier in the year when concerns about excessive franc strength and the potential for intervention lingered in the background, neither appears an especially pressing issue right now. With inflation subdued and the franc not displaying the type of appreciation that would ordinarily concern policymakers, the external backdrop screens as far more important. 

USD/CHF: Bears probe support

Source: TradingView

USD/CHF delivered a bearish key reversal candle on Thursday last week, kicking off a slow downward grind ahead of both rate decisions. The pair now finds itself testing former resistance at 0.7925, making it the immediate downside level in focus.

Underneath, bears face a zone comprising the 200, 50 and 100-day moving averages below, in that order, before uptrend support comes into view around 0.7830. For mine, the 200-day moving average is the one to watch, although it's notable how selective the price has been in reacting to all three going back several months. With the geopolitical environment potentially creating less headline risk, the fleeting interactions may become more consistent in the near term.

If the January uptrend were to be broken, 0.7796 and 0.7750 are the levels underneath to watch. Should the price be unable to break beneath 0.7925 support, last week's high of 0.8013 becomes relevant on the upside.

The message from the oscillators is now largely neutral, favouring a similar directional bias. RSI (14) is almost back at 50 having rolled over, while MACD is on the cusp of crossing over from above while remaining in negative territory. Momentum is shifting away from the bulls, but it's not yet with the bears.