A hawkish testimony and mostly unchanged rhetoric are expected from Fed Chairman Ben Bernanke on Tuesday, as the head of the U.S. central bank delivers the first of a two-day semiannual testimony to congress.

"In the US, all eyes will be on Ben Bernanke as he appears before Congress on Tuesday to give his semi-annual Humphrey-Hawkins testimony," said CIBC Economist Meny Grauman. "Three weeks have already passed since the FOMC decided to keep US rates on hold, but it is unlikely that the Fed Chairman will veer too far away from the tone of that meeting's accompanying statement. The risk of course is that Bernanke signals a more imminent rise in the overnight rate, but we deem that to be a low probability outcome."

On June 25, the FOMC held rates unchanged, adding the statement that, "Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased."



Most agree that the hawkish tone will be maintained given soaring gasoline prices and prospects of global inflation continuing to trend higher.

"The day after Bernanke's testimony, we expect the June CPI to print a very high 0.8%m/m increase," points out JPMorgan Economist Michael Feroli. "That, combined with the fact that some measures of inflation expectations are moving higher, should prompt Bernanke to voice strong concern about the inflation outlook and to reiterate the vow that an unanchoring of inflation expectations would be met with monetary policy action."

BTMU economist Chris Rupkey agrees. "The market is naturally thinking it will be hawkish after Bernanke's comments on June 9, and the FOMC's press statement on June 25. Downside risks are diminishing, while the upside inflation risks are rising the Fed said on both occasions."

"Despite the weakness in the mortgage and stock markets, the market seems to believe Bernanke as head of the FOMC will be hawkish on Tuesday," he added. "We are still a little more worried what the Fed might do if their second half economic recovery forecast misses the mark."

However, prospects of deterioration of growth will inevitably spill into Bernanke's testimony, said Sal Guatieri of BMO Capital Markets. "Persistent downside risks to growth would suggest the Fed is not inclined to raise rates in the near term, barring a broadening of inflation pressures. Rate hikes if necessary, but not necessarily rate hikes."

Fed fund futures are currently expecting 9.5% chance of a 25 bps hike at the FOMC rate announcement on August 5 and a 43.5% chance of a hike by September's announcement.

David Ader, Head of Government Bond Strategy and Ian Lyngen, Interest Rate Strategist at RBS, believe prospects for hikes might have been overpriced.

"Bernanke we think cannot avoid acknowledgement of the pace of weaker data in the last several weeks, the growing slack and rapidity with which UNR has reached into the central tendency's range for this cycle," the wrote in a note to clients. "We expect some relief (as has been the case with recent such testimonies) to start the course of pricing out the last of any hikes this year."

Currency strategists, on the other hand, are expecting the greenback to rebound on some of the testimony.

"Fed Chairman Bernanke's testimony to Congress tomorrow may alleviate dollar losses on the argument of renewed assurance from the central bank," said Ashraf Laidi, chief FX strategist at CMC Markets US. "The currency's best chances of recovery remain against JPY and CAD, but these are likely to remain temporary."

"USDJPY capped at the trend line resistance of 107.10, before renewed weakness emerges back to 106.20," he added. "EURUSD is supported at 1.5820 and 1.5780, which remains well above the increasingly important support of 1.5620. Upside capped at 1.5970."

By Erik Kevin Franco and edited by Cristina Markham