US Headline CPI (YoY) (JUL) (08:30 ET; 12:30 GMT)
Expected: 2.4%
Previous: 2.7%

US Core CPI (YoY) (JUL) (08:30 ET; 12:30 GMT)
Expected: 2.2%
Previous: 2.2%

How Will The Markets React?

Inflation growth in the US is expected to slow during the month of July, with the annualized headline CPI figure estimated to drop to a four month low of 2.4 percent, while the annualized core measure is anticipated to hold steady at a 15-month low of 2.2 percent. There are also upside risks to this reading after producer prices for the same period jumped 4.0 percent from the year prior. However, those gains were led, unsurprisingly, by energy costs as total gasoline prices surged 3.2 percent. Stripping out volatile measures such as energy and food, core producer prices rose a more moderate 2.3 percent from the year prior. Given these factors, there is a good chance that we will see headline inflation remain lofty, while core inflation – the gauge that the Federal Reserve watches most carefully – holds steady or moderates further. This should prove to be highly market moving for fixed income, forex, and equity markets, as interest rate expectations have shifted from a neutral stance last week – when the FOMC maintained that inflation remained their predominant concern – to speculation of a dovish bias – as US fixed income markets have already started to bet on a September rate after multiple global central banks started a round of cash injections into financial markets in order to soothe a widespread credit crunch. As a result, if CPI proves to be softer-than-expected, the Federal Reserve will essentially be given the green light to bail out the markets and cut rates in the near-term. On the other hand, if CPI holds strong, markets may start to reconsider current rate forecasts, as an easing of monetary policy would undermine the central bank’s inflation-fighting credibility.

Bonds – 10-Year Treasury Note Futures

Treasuries have been holding within a range trade pattern developing and that is what has unfolded, and Tuesday’s price action in 10-year note futures pressed against Friday's high at 107-305 and closed a touch lower at 107-28. Should the S&P or Dow start breaking to new lows or if Wednesday’s US CPI report is released at a weaker-than-expected figure, contracts could easily start soaring past the recent highs at 108-04 toward the April highs at 108-165. On the other hand, signs that inflation remains strong may lead Treasuries lower to 107-15, as the data could prevent the Federal Reserve from moving to cut rates.

FX – EUR/USD

The EUR/USD pair continues to plunge lower, breaking through support at the 100 SMA at 1.3553, as risk aversion trends have moved in favor of the US dollar. Furthermore, weaker-than-expected Euro-zone GDP did not help the case of the European currency, especially as the chances of a rate hike by the European Central Bank have already been diminished since global financial markets were sent reeling amidst fears of a liquidity crunch. While EUR/USD looks ready to take on trendline support at 1.3456, the release of US CPI will add major event risk to the pair. The first thing traders should keep in mind when trading the release is that the knee jerk reaction will likely be in line with the data. For example, a strong CPI reading could send EUR/USD spiking lower for a test of 1.3500 while a surprisingly weak CPI report may lead EUR/USD spike up to 1.3600. The other factor to consider is the longer-term perspective, as the immediate price reaction may not see any continuation. By and large, the US dollar still remains oversold (see the most recent COT report here), and with the currency turning into an apparent safe-haven at times of major market volatility, the trend could continue to take EUR/USD far lower throughout the next few months.

Equities – S&P 500 Index

The S&P 500 dipped lower today, testing the 1,425 level, with credit concerns coming to the forefront once again as Sentinel Management Group, a small firm that manages short-term cash for commodity-trading firms and hedge funds, asked to halt investor redemptions due to a lack of liquidity. It appears that former support at an ascending trendline and the 200 SMA have started to serve as resistance near the 1,450 level. If this is indeed the case, the S&P 500 could be in for additional declines, with a break of 1,425 targeting 1,375. The release of US CPI on Wednesday adds a heavy dose of event risk, as equity market bulls are desperately hoping for a rate cut by the Federal Reserve, and a surprisingly weak inflation report will increase the odds that they will get their wish. On the other hand, if CPI is released at a relatively strong figure, the S&P 500 may plummet as the central bank will be far less likely to consider easing monetary policy at the risk of losing their credibility.

Terri Belkas is a Currency Strategist at FXCM.