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Sinclair, 19, made five first-team appearances for Liverpool and scored on his first start against Exeter in the FA Cup in January.
The clubs have come to an agreement which will see the Merseysiders receive about £4m in compensation as a development fee applies.
He is the club's first signing ahead of the 2016-17 season.
Sinclair joined Liverpool's academy from West Bromwich Albion in summer 2011, becoming the Reds' youngest ever player when he came on as a substitute in a League Cup tie against his former club in September 2012, aged 16 years and six days.
He was loaned to Wigan in 2014-15, playing once, and leaves Anfield having made six appearances with one goal.
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Watford have signed out-of-contract Liverpool striker Jerome Sinclair on a five-year deal.