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The U.S. dollar traded at a two week low against its global peers Tuesday, while the gap between short and longer-date Treasury bonds continued to narrow, as investors extended bets on a dovish turn from the Federal Reserve at the start of its two-day rate setting meeting in Washington.

Fed Chairman Jerome Powell is expected to argue for no changes to the central bank's key interest rate, following four hikes in 2018, as inflation in the world's biggest economy remains muted and growth signals, particularly in the housing and manufacturing sectors, continue to weaken. 

"There are certainly reasons for being less optimistic about the US economy in 2019 than in 2018," said ING's chief international economist James Knightley. "Higher interest rates and the strong dollar will act as a brake on growth while the support from last year's fiscal stimulus will fade."

"Then there is weaker growth from China and Europe at a time of lingering trade tensions plus a recent batch of weaker domestic US data, coupled with the prolonged government shutdown," he added. "Given all of this, there are clear reasons to be cautious, but we think futures markets are being too pessimistic in pricing in the next Federal Reserve move being an interest rate cut."

The U.S. dollar index, which tracks the greenback against a basket of six global currencies, was marked 0.13% at a two week low of 96.40 in early Thursday trading amid increasing speculation that that Fed will signal just a single rate hike this year while slowing the pace of bond sales from its balance sheet.

The CME Group's FedWatch tool is pricing in a 98.7% probability of no rate hike tomorrow in Washington, but indicates at least a 30% chance of a rate cut -- from the current range of 2.25% to 2.5% -- by January of 2020.

Investors are also betting that Powell extends his dovish turn when he speaks to media at 2:15 pm in Washington Wednesday, with expectations he'll unveil a slowdown in bond sales from the Fed's $3.8 billion balance sheet -- which are currently running at a rate of $50 billion a month -- of as much as $10 billion in the immediate term and winding down to zero by the autumn.

Still, data from the economy remains mixed and inconsistent, suggesting Powell may not wish to commit to an overly dovish stance as trade negotiations between Washington and Beijing continue to inch forward and Britain's Brexit drama remains as unresolved today as it did more than two years ago.

U.S. wage growth is running at its hottest pace in nearly ten years, a fact which, combined with surging domestic equities -- the S&P 500 has gained 13% so far this year -- has boosted consumer confidence and job creation, despite the disappointing February reading of only 20,000 new positions, has kept unemployment at the lowest levels in five decades.

All that said, the reading investors most rely upon to gauge near-term recession risk -- the yield gap between 2-year and 10-year Treasury notes -- is flashing red, with just 14.5 basis points separating the two maturities. 

That spread, however, might be more a factor of negative real bond yields in key markets such as Germany and Japan, which have driven investors there into markets in the United States in search of fatter returns, with the corresponding price gains pushing Treasury yields lower.

The complexity of both domestic economic data, alongside mixed market signals, could put the bar for a major policy shift from Powell and company tomorrow, argues Saxo Bank's head of FX strategy John Hardy. 

"Given how far expectations have shifted and the degree to which asset markets have rejoiced over the Fed's dovish turn, the bar is somewhat high for a dovish surprise," he said. "The most obvious dovish signal, an aggressive signal on the (balance sheet sales) schedule aside, would be the expectation of no further rate increases for the balance of 2019."

"The flipside of a high bar for a dovish surprise is that it would be very easy, if unlikely, for the Fed to insist on two-way guidance, i.e. reserving the ability to hike rates if the outlook from here strengthens again," he added. "Especially now that the immediate threat of financial market instability tail risks wagging the economic dog have so thoroughly faded."

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