US Headline CPI (YoY) (DEC) (13:30 GMT; 08:30 EST)
Expected: 4.1 %
Previous: 4.3%

US Core CPI (YoY) (DEC) (13:30 GMT; 08:30 EST)
Expected: 2.4%
Previous: 2.3%

What Are The Markets Facing?

At this juncture, there is little doubt that the Federal Reserve holds an extremely dovish bias, especially since they’ve already cut the federal funds rate by 100bp since September. Meanwhile, Fed Chairman Ben Bernanke made this stance even more clear last week when he said, “additional policy easing may well be necessary…we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.” As a result, futures markets have rapidly shifted to fully price in a 50bp rate cut on January 30 and a 50 percent chance of a 75bp cut; but with major US event risk scheduled to be released this week, these expectations could still change. Indeed, one of the major factors that has left the Fed feeling hesitant to slash rates is inflation, as CPI has climbed throughout much of the fourth quarter on the back of sky-high commodity prices. These building price pressures leave Bernanke & Co. in a very precarious position, as a recession appears to be very probable and the financial markets remain unstable. However, stagflation (a major economic slowdown AND accelerating inflation) would be even worse and by making monetary policy more accommodative, they run a greater risk of encountering such a scenario. As a result, if headline CPI eases in line with expectations, traders will only increase their bets that the Fed will cut rates by at least 50bp at the end of the month.

Bonds – 10-Year Treasury Note Futures

Treasuries continue to look bullish as they broke above the 115-24 high, especially as US retail sales raises speculation that the economy is already in a consumer and housing-led recession that only needs to be confirmed by GDP figures. Wednesday’s US event risk may prove precarious for Treasuries as well, with an easing in CPI figures likely to buoy the contract through 116-02 towards 117-03.

FX – EUR/USD

The EUR/USD break above 1.4820 was a bullish sign of things to come for the pair, as there is little to stand in the way of a push to record highs in the near-term. The gains for the pair (and losses for the US dollar) have come as Federal Reserve Chairman Ben Bernanke issued extremely dovish commentary last week, which led traders to aggressively ramp up expectations for a January rate cut of up to 75bp. Weaker than expected US Retail Sales didn’t help the beleaguered currency either, as analysts judge that the economy may already be in recession. On Wednesday, US CPI could propel EUR/USD even higher, especially if the figures soften in line with or more than forecasts. Indeed, lower-than-expected PPI numbers suggest that this may be the case, but if CPI actually proves to be strong the markets may judge that Fed rate cut outlooks are overdone which could be quite bullish for the greenback in the near term.

Equities – Dow Jones Industrial Average

The daily charts of the Dow Jones Industrial Average look highly bearish, especially after the index plunged through the psychologically important 13,000 level. Where the Dow goes from here will depend primarily on the status of risk aversion in the markets as well as financial market news, but it is worth noting that immediate support looms below at 12,518. Weaker than expected US retail sales and news that Citigroup posted a $10 billion loss in Q4 will likely weigh on the Dow on Tuesday and CPI data on Wednesday may contribute to further declines as well as they are forecasted to support the case for a sharp rate cut by the Federal Reserve on January 30. On the other hand, equity traders could shrug off the news to leave the Dow consolidating above 12,500.

Terri Belkas is a Currency Strategist at FXCM.