US Dollar Forecast: DXY Surges as Oil Spike Fuels Fed Rate Hike Fears

Dollar Surges as War Rewrites the Rate Outlook

The U.S. Dollar is sharply higher for a second session against a basket of major currencies on Tuesday. A key shift in investor sentiment over the weekend at the start of the war between the United States and Iran is the fundamental catalyst behind the rally.

Here it is in a nutshell. The U.S. and Israel attacked Iran on Saturday. The market had anticipated the attack but not necessarily the timing of the event. This had been underpinning crude oil for months. The actual start of the war put a little more upside pressure on oil with the retaliation from Iran, elevating prices even further. It’s the retaliation that may be driving the U.S. Dollar higher and impacting gold and other currencies.

Why Higher Oil Prices Are a Dollar Catalyst

The way I see it, higher crude oil prices are acceptable, but higher prices over a prolonged period of time are not. Iran is not only fighting the U.S. in response to the initial attacks, but it’s also firing missiles at neighboring countries, trying to hit refinery infrastructure. Perhaps they are trying to anger OPEC into putting pressure on the U.S. to stop the fighting — I don’t know for sure. But I do know that damaged infrastructure can’t produce oil, so the move qualifies as a possible supply disruption.

I think the market was ready for the closing of the Strait of Hormuz, a key waterway that tankers use to transport oil to Europe and Asia. It accounts for about 20% of global production. The Strait can open and close at will, depending on how strong Iran’s defense of the area is. According to Iranian media, it’s closed. However, infrastructure damage can take months to repair, meaning that the world may face a more prolonged shortage of oil than previously anticipated.

Inflation Fears Put the Fed Back in Focus

This is where the rise in the dollar comes into play. Elevated oil prices are inflationary and it’s something the world may not be ready for, especially with the European Central Bank (ECB) already focused on maintaining a low rate environment. Meanwhile, the Fed has been sitting on the fence about cutting rates. The market anticipates at least two rate cuts this year, but the Fed has been committed to the data. Friday’s jobs report will encourage the Fed to lean either way, but a big jump in inflation will force the Fed to remain on hold, and may even push them toward a rate hike.

It’s inflation and rate hike fears that are driving the U.S. Dollar higher. The higher crude oil moves for longer, the greater the odds of a Fed rate hike, and that is scary for dollar short-sellers, who previously bet big on the Fed cutting rates.

If conditions improve in the Middle East then the dollar could retreat quickly, but if they worsen over time, the U.S. Dollar could jump another 10% from current levels.

Technical Outlook: New Support, New Targets

Technically, the main trend is up according to the daily swing chart. The current two-day rapid rally was initially fueled on Monday with the breakout over the 50-day moving average at 97.919 and extended today when the 200-day MA at 98.353 was overtaken. These indicators are now support.

Furthermore, after taking out the swing top at 98.078, the trend turned up based on this indicator. Its new targets are the swing tops at 99.492 and 100.395.

Fundamentally, look for the dollar to strengthen if higher oil prices drive up the chances of a Fed hold in June and a possible rate hike. Technically, the DXY should remain in a bullish position as long as it remains above the 50- and 200-day moving averages.

More Information in our Economic Calendar.