The US will see the release of CPI and retail sales data for January on Wednesday, at 1330 GMT. Forecasts suggest that inflation is set to slow somewhat, while retail sales excluding automobiles are anticipated to rise at the same pace as previously. These data - and particularly the inflation prints - could play a large role in determining how many times the Fed will raise interest rates this year, and thus may dictate not only the dollar's short-term bias, but also whether the recent volatility in stocks will heighten or subside.
Both the headline and the core CPI rates are anticipated to have declined to 1.9% and 1.7% respectively in yearly terms, from 2.1% and 1.8% previously. As for retail sales, the headline print is expected to have slowed to 0.2% month-on-month from 0.4% previously, while the core figure that excludes automobile sales is projected to have risen at 0.4%, the same pace as the previous month.
It's not an exaggeration to say that this set of inflation data may hold special importance for both investors and policymakers. Let's not forget that the recent stock market turmoil started after the US surprisingly reported an acceleration in wage growth, which generated speculation that inflation may be set to pick up soon and consequently sent US bond yields sharply higher. Higher bond yields, in turn, weigh on demand for equities, as bonds now begin to produce adequate returns to keep investors interested. Thus, bond and equity investors are likely to look at the CPI prints to either confirm or disprove the narrative that a surge in inflation is just around the corner.
Of course, the CPI figures are likely to hold large implications for the dollar as well, which has managed to stabilize and even claw back some of its losses over the past days. At the time of writing, markets have fully priced in two Fed rate hikes by year end, and also see a 40% probability for a third one according to the Fed funds futures.
A potential upside surprise in the CPIs - and especially in the core rate - is likely to reinforce the narrative that inflationary pressures have started to intensify. Something like that would probably send higher both the probability for a third Fed hike this year and US Treasury yields. The dollar would probably benefit from such an outcome, as higher yields are generally positive for the currency (though this relationship has become dubious lately). Dollar/yen is likely to surge and break back above the key hurdle of 108.00, potentially aiming for the 108.50 zone. Should the bulls manage to overcome that barrier, then the 109.30 area could come into play. Higher yields, though, would also exert greater downward pressure on equity indices. The Dow Jones may head lower in this scenario and test the 23780 support territory, marked by the lows of February 8. A potential downside break of that level could pave the way for extensions towards the index's recent lows, near 23360.
Conversely, softer-than-expected inflation prints could weigh on the dollar, but provide some much-needed relief to stock indices. Dollar/yen could edge lower and possibly break below the September low of 107.30, potentially aiming for a test of the 106.80 level, identified by the high of 24 June 2016. If sellers are strong enough to overcome that hurdle as well, then support may be found near 105.60, marked by the high of October 2016. As for the Dow, it is likely to rebound in such a case and aim for the 25300 resistance, marked by the peaks of February 7. An upside break of that area is possible to set the stage for extensions towards the January 16 low, at 25700, with even further advances likely to test the psychological 26000 territory.