Markets calm pre-Fed, EUR inflation expectations tank to all-time low

Investors in equity and foreign exchange markets are reluctant to take a direction before this weeks much expected Federal Reserve (Fed) decision. The S&P500 (+0.09%) and the Dow (+0.09%) closed flat on Monday. NASDAQ gained 0.62%, as technology stocks rallied.

The Fed will give its policy verdict on Wednesday and is expected to maintain its policy unchanged. However, markets are obsessed with the Feds next move, since the Fed Governor Jerome Powell said that they are ready to cut the interest rates, if needed. The Fed expectations sharply moved from patient to two-to-three rate cuts within the next twelve months.

Now it is time to see whether Powell meant such a drastic policy shift. Despite the ongoing trade disputes and the weakness in the latest jobs report, the US economy grew just fine. The first quarter GDP printed 3.1% growth, while the unemployment rate is at two-decade lows. But some indicators hint that the good vibes in the US economy may not last. The Empire Manufacturing index printed the biggest one-month drop in history. The index dropped from 17.8 to -8.6 in June, leaving the already-soft expectation of 11.0 well behind. The inflation expectations in the US hit the lowest levels since 2016.

One thing is clear, the market is positioned for a dovish Fed. The question is, will the Fed sound as dovish as expected by the market?

In fact, the recent shift in Fed expectations created a domino effect. The Bank of Japan (BoJ) and the European Central Bank (ECB) announced that they could also lower their rates, despite being already in the negative territories. Meanwhile, the Reserve Bank of Australias (RBA) latest meeting minutes stated that further policy easing is more likely than not in the period ahead, after lowering its policy rate by 25 basis points this month.

As a result, the actual market expectations and other central banks dovish positioning could eventually force the Fed to act sooner, or sharper than it otherwise would. This is because the policymakers consider the market expectations and ride in tandem with investors to allow a smooth transition of policies into the market.

Hence, this weeks FOMC meeting is the moment of truth for Fed watchers. Have the markets gone beyond the Feds thinking? If so, will the Fed readjust its stance according to what markets demand. The Feds dot plot will perhaps give a clearer scope for what could happen in the coming months. A less dovish readjustment in the language could be a disappointment for the markets and send the US stock and bond markets tumbling. Therefore, the Fed could choose to follow the markets lead and deliver a sufficiently dovish verdict until the dust settles.

The US 10-year yield consolidates below the 2.10% mark, as the US dollar softens against the G10 currencies this morning, except the Aussie and the pound.

Rising no-deal risk could hold the pound back from recovery

The pound cheapens on rising hard-Brexit concerns, as the EU-sceptic Boris Johnson will likely take the reins as the new Conservative leader and the UKs next Prime Minister. The Brexit negotiations could take another turn under Johnsons lead; the rising probability of a no-deal exit should continue weighing on the pound.

The second round of leadership vote will be held today, and ballots will continue until two candidates are left.

Meanwhile, the UK stocks continue benefiting from a softer pound. The FTSE 100 closed 0.16% up on Monday and the FTSE futures (+0.06%) hint at a slightly positive start on Tuesday.

The FTSE is expected to open 10 points higher at 7368p. Yet softer energy and commodity prices could limit the upside potential on Tuesday.

Oil markets are weaker after the US Empire Manufacturing shocked on the downside, while OPEC and its allies didnt manage to set a meeting date, where they are expected to announce another round of production cuts to readjust their supply to a weakening global demand.

Eurozone inflation expectations hit an all-time low

The EURUSD consolidates a touch above the 1.12 mark ahead of the Eurozone inflation data. Investors become increasingly sensitive to inflation, as the euro 5y5y inflation swap forward, a gauge for inflation expectations, plunged to the historical low of 1.1375% in June, despite the ECBs negative interest rates and the prospects of additional TLTRO (Targeted Long-term Refinancing Operation). Todays read should confirm a slowdown in consumer prices to 0.2% m-o-m in May versus 0.7% printed a month earlier. The core inflation is seen steady at 0.8% on yearly basis. A soft inflation could revive the ECB doves and weigh on the single currency, yet the euros short-term strength against the US dollar will likely depend on the broad-based US dollar appetite.

In longer-term, even with softer US rates, the gap between the US and euro rates hint that the US dollar has further room to appreciate against the single currency, though the appreciation could be slower.