USD breaks bull flag above 101.80 as FOMC decision looms

The dollar index surged through the 101.80 Fibonacci resistance on July 24, extending a rally that began after the June FOMC meeting and setting up a pivotal test for the Federal Reserve's July rate decision.

The dollar broke above the 101.80 Fibonacci resistance level on July 24, extending a rally that began after the June FOMC meeting as traders priced in an 81.4% probability of a rate hike by September, up from 52.4% a week ago.

"The breakout above 101.80 confirms the bullish momentum that started after the June FOMC meeting, and the question now is whether the Fed delivers a hawkish surprise next week," said Joseph Trevisani, senior analyst at FXStreet in New York.

The dollar index rose 0.36% to 101.47, on track for its biggest daily gain in a month. The euro fell 0.33% to $1.1372 after the European Central Bank held rates steady but left the door open for a September increase, with markets pricing a 71% chance of a hike, according to LSEG data. The yen weakened 0.41% to 163.79 per dollar, touching 163.98, its softest level since November 1986, as expectations of a gradual approach to rate hikes at the Bank of Japan contrasted with the Fed's hawkish repricing. Oil prices added to the dollar's strength, with Brent crude touching $100 a barrel for the first time since May 26 after geopolitical tensions escalated in the Middle East.

The breakout sets up a binary event for the FOMC decision on July 30-31. Markets now price a 35.8% chance of a hike at next week's meeting, up from 11.8% a week ago, according to CME FedWatch. If the Fed delivers a hawkish hold or a surprise increase, the dollar could extend its gains against the euro, yen, and sterling, with the 101.80 level shifting from resistance to support. A dovish outcome risks a sharp reversal that would test the bull flag's validity.

The rally in the dollar has been fueled by a confluence of factors beyond the FOMC. U.S. economic data continues to surprise to the upside, with weekly initial jobless claims dropping by 22,000 to 187,000 in the latest reading, well below the 212,000 estimate from economists polled by Reuters. The labor market resilience, combined with the recent rebound in oil prices, has fanned inflation fears and pushed up expectations for rate hikes from the Federal Reserve.

The last time the dollar traded at these levels against the yen was in November 1986, when the Plaza Accord was still reshaping global currency markets. Japan's 2-year government bond yield hit a 31-year high on July 24 on growing bets that the BOJ would accelerate the pace of interest rate hikes, yet the yen continued to weaken as the rate differential with the U.S. widened. Akira Otani, senior Japan research economic adviser at Goldman Sachs, said in a note the bank expects the BOJ "will maintain the status quo at the July meeting, and continue to expect the next rate hike in January next year," but cautioned that the timing of hikes is "likely to be significantly influenced by market developments and the degree of progress in communication with the government." Japan's finance minister reiterated the government was prepared to take decisive action on foreign exchange as needed, after carrying out yen-buying operations in April and May.

Across the Atlantic, the ECB's decision to hold rates at its July meeting kept the euro under pressure. President Christine Lagarde said "while developments in underlying inflation have remained contained, the full effects of the energy shock have yet to play out," leaving the door open for action in September. Analysts at Morgan Stanley said in a note that a hike from the central bank would be positive for the euro, as markets are not pricing in a deep enough restriction to hurt the currency.

For the dollar, the immediate catalyst remains the FOMC. Multiple Fed officials, including Chair Kevin Warsh, have highlighted concerns about inflation pressures over labor market concerns, helping push up market expectations for rate hikes. The 81.4% probability of a September hike, up from 52.4% a week ago, reflects a rapid repricing that has caught many currency traders off guard. If the bull flag breakout holds, the dollar could target the next resistance zone above 102.50, a level not seen since the early 2000s. If it fails, the 100.80 support level becomes the first line of defense.

This article is for informational purposes only and does not constitute investment advice.