US Headline CPI (YoY) (OCT) (13:30 GMT; 08:30 EST)
Expected: 3.5%
Previous: 2.8%

US Core CPI (YoY) (OCT) (13:30 GMT; 08:30 EST)
Expected: 2.2%
Previous: 2.1%

How Will The Markets React?

With energy and food prices in the US rocketing higher, it will come as little surprise that inflation figures for the month of October are expected to surge upon release on Thursday. However, federal fund futures currently price in an 82 percent chance of a rate cut by the Federal Open Market Committee on December 11th as the credit markets remain extremely tight, leaving the US equity markets particularly susceptible to declines. The health of the financial markets is clearly of importance to the Federal Reserve, but the matter of whether the bank is essentially “bailing out” the stock markets and companies that irresponsibly got caught in the borrow-short-lend-long squeeze during August is still being debated. Indeed, we’ve seen that when the Dow plummeted last week, expectations of a 25 basis point cut rocketed higher to 98 percent, but after Monday’s recovery in the stock markets, expectations have edged lower. What about that pesky inflation issue and the Federal Reserve’s price stability mandate? Headline CPI is expected to have climbed to an annual rate of 3.8 percent – the highest since August 2006 – while core CPI is anticipated to tick up to an annual rate of 2.2 percent. Federal Reserve Governor Frederic Mishkin said recently that core inflation measures, which exclude food and energy costs, are a “better guide” as they “provide a clearer picture of underlying inflation pressures.” This focus would suggest that the FOMC potentially has more room to cut rates. However, it is worth noting that core CPI also happened to be stable at these levels throughout late 2004 through early 2006 – the same period of time that the FOMC was aggressively raising interest rates. Clearly, the Federal Reserve can argue both sides (to cut rates or to leave rates steady), but if cooler heads prevail come December 11th, the central bank will likely keep these inflation figures in mind and leave the federal funds rate at 4.50 percent.

Bonds – 10-Year Treasury Note Futures

Treasuries extended the slide from the 112-05 highs, but support at the 111-08 level has thus far prevented further declines. Economic data out of the US on Wednesday (retail sales, PPI) could shake the contracts up, but Thursday’s data is likely to weigh Treasuries down as signs that inflation is spiraling higher may prevent the FOMC from cutting on December 11th.

FX – EUR/USD

EUR/USD has bounced strongly from the 38.2 percent Fibonacci retracement level of the rally from 1.4130 to 1.4751 at 1.4519. However, the 1.4700 level has been able to hold back gains for the pair for now, but upcoming US event risk may ignite another round of dollar selling. On Wednesday, US retail sales data could help push EUR/USD to continue testing resistance, but things could change on Thursday as US CPI reports are likely to show that oil and food prices are leading inflation pressures to mount significantly, which has the potential to prevent the FOMC from cutting rates on December 11th. If the figures are actually stronger than expected, the US dollar could find itself bid once again and the news may push EUR/USD down to break 1.4635/40 for a test of 1.4590 upon a break. On the other hand, once greenback bears take control, they are hard pressed to let go and if we see that Fed fund futures continue to aggressively price in a 25bp cut, EUR/USD could continue to ascend to the record highs at 1.4751.

Equities – Dow Jones Industrial Average

The Dow Jones Industrial Average has plunged precipitously over the past two weeks, but the index managed to stabilize and rebound from the 13,000 level to break through 200 SMA and Fibonacci resistance at 13,225/60. However, Wednesday’s Advance Retail Sales report – which is expected to show a slowdown in consumption – and the Producer Price Index - which may highlight mounting inflation pressures – could throw the rally off track as it will only allow the equity market’s concern that the Federal Reserve will not cut rates again in December to percolate. Thursday’s CPI data may also exacerbate this sentiment, as while expansion in the US is clearly taking a hit amidst the collapse of the housing sector, upside inflation risks may be too great for the central bank to slash the federal funds rate by 25bp again in December. As a result, the Dow could continue its descent this week, with a break of 13,000 targeting the August lows at 12,517.94. On the other hand, volatility (as indicated by the VIX index) has fallen back sharply, which suggests that the return to carry trades will allow the Dow to continue higher for a test of 13,563/85.

Terri Belkas is a Currency Strategist at FXCM.