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US inflation data key test for dollar bulls

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Dollar bulls are betting U.S. data this week will show consumer prices picked up last month, bringing inflation closer to the Federal Reserve's 2 percent threshold it has set for considering a rate hike, CNBC's latest market survey of currency traders, analysts and strategists showed.

The U.S. dollar index (DXY) - which measures the dollar against six major currencies - recovered from a 20-month low of 78.906 set last Thursday after European Central Bank (ECB) chief Mario Draghi warned that the euro's strength was "a serious concern" and that the ECB was "comfortable" with taking more action to support economic growth and raise inflation at its June meeting. The euro has a near 58 percent weighting in the DXY.

The strength of this week's scheduled U.S. data releases - which include the closely-watched April consumer price index (CPI) on Thursday - and the bearing it has on Fed rate expectations will decide whether the dollar continues its turnaround, strategists said.

Read MoreAre the dollar's days as a carry trade numbered?

"U.S. economic data started to improve relative to expectations in the beginning of April and I am expecting more of the same to scatter doubts about the continuity of the Fed's tapering effort and feed speculation about eventual interest rate hikes," said Ilya Spivak, Global Macro strategist for DailyFX.com, who holds a 'bullish' view on the dollar this week. "An expected nine-month high of 2 percent on headline year-on-year CPI this week ought to reinforce this dynamic."

In addition, preliminary University of Michigan consumer confidence for May on Friday "will be important to watch as well, with upside surprises likely to drive USD higher," Spivak told CNBC in emailed comments.

Read MoreThe declining dollar: Why everyone got it wrong

Fed rate hikes

Consensus forecasts show April's core CPI up 1.7 percent from a year earlier, unchanged from the prior month's reading.

"If it (CPI) starts to rise at a faster pace as America's labor market tightens, investors will bring forward their expectations of the Fed's first rate hikes," said Mansoor Mohi-uddin, head of foreign exchange strategy at UBS. "We continue to forecast the dollar rising to 1.25 against the euro and 110 against the yen this year."

Read MorePayrolls, inflation data may salvage dollar

Sentiment in this week's CNBC market survey is almost evenly split between dollar bulls and bears. Forty three percent say the dollar will extend gains, 46 percent say the greenback will weaken while 11 percent say the dollar will trade at current levels.

Dollar bears maintain inflation remains low and highlight the Fed's preferred gauge of inflation - the price index for personal consumption expenditures - which has run below 2 percent for 23 consecutive months.

Moreover, Fed Chair Janet Yellen warned last week about the risks posed to the recovery from the U.S. housing market slowdown, suggesting that the Fed may be in no hurry to raise rates. Across the Atlantic, ECB chief Mario Draghi has left the door open for further easing measures possibly in June.

Read MoreDollar stifled by weak labor force participation

Both Yellen and Draghi striking dovish tones complicates the euro-dollar outlook, said Paul Mackel,head of Asia currency research at HSBC: "How do you get euro-dollar down? It's telling you that it'snot the best trade."

Simon Derrick, chief currency strategist at BNY Mellon went further: "It looks like currency wars are back with the ECB and the Fed at the center of the battle. For the moment it looks like the dovish signals from Janet Yellen will outweigh those from Mario Draghi."

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