US Dollar Rally Builds Momentum, Crude Oil Holds the Key

The US dollar is building momentum as crude oil prices surge on escalating tensions in the Middle East, reviving inflation concerns and lifting expectations for further Federal Reserve tightening. While futures positioning is approaching a bullish extreme, technical and macro signals suggest the US Dollar Index (DXY) may still have room to extend towards 102.

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Crude Oil Surges as Middle East Tensions Escalate

Crude oil prices extended their rally on Thursday as escalating tensions in the Middle East fuelled fears of further supply disruptions. Iran-backed Houthi rebels claimed responsibility for attacks on two Saudi oil tankers in the Red Sea, while the US launched another round of strikes on Iranian targets, prompting President Trump to vow "major military punishment". With shipping risks rising across both the Bab el-Mandeb Strait and Strait of Hormuz, traders pushed up the geopolitical risk premium in crude.

Crude oil has rallied more than 40% in just three weeks, renewing concerns about inflation and the potential for a prolonged conflict in the Middle East. Note on the daily WTI and Brent crude charts that trading volumes and daily volatility are increasing as the rally matures and supply disruption fears continue to underpin sentiment. Brent crude is trading above $100 and within sight of the 26 May gap resistance, leaving it up around 45% from its recent low.

Source: NYMEX, ICE, TradingView

US Dollar Sentiment Nears an Extreme, Though Crude Oil Holds the Key

The US dollar also strengthened as investors sought safe-haven assets, while higher oil prices reinforced inflation concerns, lifting US Treasury yields and increasing expectations for further Federal Reserve tightening. Fed funds futures currently imply a 57% probability of a rate hike in September and a 39% chance of a follow-up increase in December.

I have noted in recent COT report articles that bullish exposure in the US dollar futures market may be approaching a sentiment extreme. However, given the data is published with a one-week lag, it does not necessarily signal a market top—only something to monitor in the weeks ahead. It could still allow the US dollar index to reach my 102 upside target over the near term.

If traders are ultimately dealt a swift resolution to the conflict in the Middle East, crude oil prices could reverse lower, dragging the US dollar with them as inflation concerns ease and expectations for further Federal Reserve tightening are scaled back.

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US Dollar Index Targets 102, Bull Flag Remains in Play

According to the latest COT data, aggregate net-long exposure to the US dollar stood at $38.5 billion, just $1.3 billion below the 10-year high reached the previous week. Asset managers' net-long exposure rose to a 78-week high of 22,000 contracts. While this may represent a sentiment extreme by recent standards, positioning exceeded 300,000 net-long contracts in 2022. If crude oil prices continue to rise, the US dollar could still have room to extend its rally.

Ther weekly US dollar index chart remains in a solid uptrend and is respecting the 10-week EMA. And with momentum turning higher from a potential bull flag pattern, the May high (101.82) and 102 seem are within site for US dollar bulls. A break above here assumes trend continuation.

Source: CFTC (COT), IMM, ICE, LSEG

US Dollar Index (DXY) Technical Analysis

The daily chart shows momentum is clearly turning higher and realigning with the broader bullish trend. The 20- and 50-day EMAs are behaving like a support cloud, while the notable increase in trading volume on Thursday suggests strong bullish participation following the rebound from the 20-day EMA. A breakout from a bull flag appears to be underway.

The flag projects an approximate upside target of 102.50, although 102 is an obvious level where an initial shakeout could occur if prices continue higher from here. My bias remains bullish while prices hold above last week's swing low, although the November and April highs, along with the 20-day EMA, are also potential support levels where bulls may look to buy any retracement.

Source: ICE, TradingView

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-- Written by Matt Simpson

Follow Matt on Twitter @cLeverEdge

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