Markets are in a cautiously optimistic mood and the dollar is coming under sustained pressure ahead of this morning’s consumer inflation report. Equity futures are up, Treasury yields are down, and risk-sensitive currencies are seeing solid inflows as traders bet US monetary policy expectations reached their cycle top last week – a view that could prove vulnerable if prices rise by more than expected.

Economists think headline prices probably continued their gasoline-powered descent in August, with the core measure rising as other areas of the economy caught up. Investors are overwhelmingly positioned for a 75 basis-point hike at next week’s Federal Reserve meeting, but rates at longer time horizons are in flux, and market turbulence could ensue if the print comes in wide of the mark in either direction.

Consumer inflation expectations are falling. August survey data released yesterday by the New York Fed showed consumers expecting prices to rise 5.7 percent over the next year, down from 6.2 percent in July. Three-year expectations dropped to an annualized 2.8 percent from 3.2 percent, suggesting that the general population thinks the central bank will succeed in bring inflation back into its target range over time.

The euro continues to ratchet higher as monetary tightening expectations climb and energy prices subside. After a series of leaks in recent weeks, investors are betting the European Central Bank will deliver a second 75 basis point hike on October 27. Geopolitical risks are subsiding as Ukraine’s military offensive gains traction, and a big infrastructure push is putting natural gas benchmarks under pressure, improving the outlook for trade balances. From a technical perspective, the euro-dollar exchange rate is nearing short-term resistance in the high 1.01’s, with a topside break likely to open up a run toward early-August levels around 1.0359.

The Canadian dollar is holding steady, failing to gain momentum on a broad-based improvement in risk sentiment even as oil prices inch upward. The benchmark West Texas Intermediate price is holding below $90 a barrel, while Brent is going for $95 – but last week’s data suggests the economy is likely to slow down as higher interest costs weaken the country’s all-important real estate market. With rate differentials narrowing on the short end, maple-flavoured two-year government bonds are paying just 5 basis points over their US equivalents, while the ten-years trade at a 20-point discount.

Beyond this morning’s inflation print, no major data releases are in the docket for today, but we would note that both the August retail sales number on Thursday and the University of Michigan’s latest survey on Friday could be market-moving. Fed Chair Jerome Powell said policymakers will look at the “totality” of data when making next week’s decision, and big variances in consumer spending patterns could play a role in shifting the central bank’s communication strategy.

Karl Schamotta, Chief Market Strategist