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Anticipation Builds Ahead of Critical US Inflation Report

Markets are on high alert ahead of what might be the post-pandemic world’s most consequential economic data release: the US consumer price index. Consensus estimates suggest headline prices fell 0.1 percent month-over-month in December, decelerating to 6.5 percent annualized from 7.1 in the month prior. Excluding food and energy, prices are expected to rise 0.3 and 5.7 percent.

The risk of a violent adjustment in foreign exchange markets is real: an above- or below-consensus print could trigger a reappraisal of the odds on a 50 basis point hike at the Federal Reserve’s February meeting, and unleash sharp short-term moves in the dollar.

But unusually-low implied volatility levels suggest market participants are unworried about lasting consequences for the policy trajectory: currency options are showing little evidence of a ramp in uncertainty over the months ahead, and the VIX volatility index—sometimes known as the “fear gauge” for equity markets—remains relatively low. Investors are almost all-in on bets inflation has peaked and the Fed will pivot toward providing economic stimulus by year end. Until that changes, the trade-weighted dollar will remain on the defensive.

The Japanese yen jumped more than 1 percent against the dollar last night after an unsourced report in the Yomiuri Shimbun newspaper said the Bank of Japan was considering making additional changes in its bond-buying programme at next week’s policy meeting. The central bank, which presides over a financial system that holds vast offshore assets, shocked markets by raising its yield curve cap in December, convincing many participants that additional tightening efforts would be in the offing for 2023. The exchange rate is now flirting with the 130 threshold, raising the possibility of a breakthrough to the topside.

The euro continued its ascent overnight, inching up relative to the dollar while making strides against the pound and Swiss franc. The common currency has risen almost 14 percent in dollar terms since hitting a multi-decade low in November, with falling natural gas prices, improving export prospects, a hawkish European Central Bank, and surprisingly-resilient sentiment levels providing momentum – but a sharp unwind in interest differentials and the currency is possible if US inflation rates fail to fall in line with expectations. We’re also awake to the possibility of outperformance in the pound as the UK passes its own “peak pessimism” moment.

Jobless claims are expected to rise to 210,000 in the week ended January 7, up slightly from 204,000 in the prior week. Markets won’t notice.

Federal Reserve speakers include Philadelphia’s Harker, St. Louis’s Bullard, and Richmond’s Barkin. As a voting member of the central bank’s rate-setting committee, Patrick Harker’s reaction to this morning’s inflation print will be closely examined for guidance on what might come next. President Biden is also likely to discuss inflation dynamics when he speaks this morning.

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