On Tuesday morning, traders had been ramping up speculation of a 25bp cut to the federal funds rate. However, the FOMC caught investors off guard when they went through with not only a 50bp cut to the federal funds rate, but also a 50bp cut to the discount rate. The policy moves signaled two things: they are worried about a possible recession and they are concerned about the credit crunch. Equity markets have taken the news kindly, while the US dollar has plummeted across the board. However, with the FOMC still saying that “some inflation risks” remain, we may not see a repeat of this in October.

Yield Spread Analysis 09/11 – 09/18

Yield curves around the globe generally flattened over the course of the past week, with the long end edging higher as concerns of a debilitating credit crunch subsided. There were a few regions whose bond markets drew quite a bit of attention. First, the surprising FOMC rate decision actually saw rates edge slightly higher, as the statement’s reference to inflation risks sent the message that the central bank may not cut rates again in the near-term. In the UK, risk aversion sent shot-term gilts rocketing higher and yields lower, as the Bank of England’s bailout of Northern Rock left traders worried that other banks may be facing a similar credit crisis and eliminated the chances of a rate hike by the central bank. Meanwhile, short-term rates in Switzerland took a hit as the Swiss National Bank raised rates, but failed to clearly signal that their rate normalization cycle would continue.

Looking ahead, the Bank of Japan’s policy meeting should not spark much price action for JGB’s. Instead, government bond traders will keep their eye on broad risk seeking trends, leaving upside risks for global bond yields.

US Fed: Bernanke To The Rescue With A 50bp Cut

On Tuesday morning, traders had been ramping up speculation of a 25bp cut to the federal funds rate. However, the FOMC caught investors off guard when they went through with not only a 50bp cut to the federal funds rate, but also a 50bp cut to the discount rate. The policy moves signaled two things: they are worried about a possible recession and they are concerned about the credit crunch. Equity markets have taken the news kindly, while the US dollar has plummeted across the board. However, with the FOMC still saying that “some inflation risks” remain, we may not see a repeat of this in October.

FOMC Statement

“Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.” – September 18, 2007

“Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.” – September 18, 2007

“Developments in financial markets since the Committee s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.” – September 18, 2007

Henry Paulson, US Treasury Secretary

“There is great vigilance now on the part of regulators, in terms of staying close to markets, as we work our way through this situation. We want to get the balance right...we don't want to rush to judgment and overreact.” – September 17, 2007

“There will be some penalty to our growth but I feel confident that our economy is going to continue to grow, that inflation is contained.” – September 14, 2007

ECB: Has The Monetary Policy Tightening Cycle Come To An End?

The European Central Bank remains concerned about the potential for inflation pressures, but do they really have any leeway to raise rates? With other central banks flipping from hawkish biases to markedly neutral ones (i.e. the Bank of England), along with continued volatility in the financial markets, plummeting investor confidence, and softening CPI figures, it appears that the European Central Bank’s tightening cycle may have come to an end:

Jean-Claude Trichet, European Central Bank President

“Risks to Euro-zone price stability remain on the upside.” – September 14, 2007

“Everybody knows that we are not facilitating in any respect those who behave improperly. On the contrary, we are protecting those who behave properly against the turbulence and the drawbacks that are coming from those that are behaving improperly.” – September 17, 2007

Klaus Liebscher, European Central Bank Governing Council Member

“On the inflationary side, upside risks are prevailing - the higher oil price, basic food products that are becoming more expensive, higher salaries driven by the good economic situation.” – September 17, 2007

Yves Mersch, European Central Bank Governing Council Member

“The volatility of financial markets and the reevaluation of risk in the last weeks has driven the growth in uncertainty in the euro zone. Given this elevated degree of uncertainty, it is appropriate to collect and examine new information before drawing conclusions about monetary policy. The (ECB) governing council will continue to follow these developments very closely.” – September 13, 2007

Sarkozy is on the attack once again and criticizing the ECB for their recent policy actions:

Nicolas Sarkozy, French President

“It’s strange to me that they're injecting liquidity without cutting interest rates. They are making life easier for speculators and harder for businessmen.” – September 17, 2007

Axel Weber, European Central Bank Governing Council Member

“The news value of Sarkozy’s critique is zero. And it also has zero influence on the ECB.” – September 17, 2007

BOE: Cautious Stance Will Keep Rates Steady At 5.75%

A credit crunch in the UK markets clearly persists, as the Bank of England and the government had to guarantee the funds of troubled mortgage-lender Northern Rock, as customers staged a bank run in fears they would lose their savings. With other banks in the UK likely to be caught in the borrow-short, lend-long squeeze as well, the Bank of England will remain cautious in coming months. While this signals that the central bank will not raise rates any further, they are just as unlikely to cut rates:

Mervyn King, Bank of England Governor

“The current turmoil, which has at its heart the earlier under-pricing of risk, has disturbed the unusual serenity of recent years, but, managed properly, it should not threaten our long-term economic stability.” – September 12, 2007

“Changes in the distribution of assets across the financial sector…are likely to have consequences for the wider economy through the interest rates for borrowing and lending faced by households and companies. It is too soon, however, to quantify the impact on the economy as a whole…If risk continues to be underpriced, the next period of turmoil will be on an even bigger scale.” – September 12, 2007

Alistair Darling, UK Chancellor of the Exchequer

“What is encouraging from our point of view here in the United Kingdom is that the fundamental positions - the strong economy, the fact that we have got low interest rates and low inflation which we haven't had in the past - do stand us in good stead and that is very, very important. We have had shocks to the system in the recent past with the collapse of the Asian markets in the late 1990s, with the collapse of the American stock market earlier in this decade. Both of those instances we dealt with, our economy carried on growing when others faltered. So that strong economy is absolutely crucial.” – September 17, 2007

“My objective all the time is not just to have a strong and stable economy but to ensure we've got stability in the banking system. That is why I authorized the Bank of England to provide that support for Northern Rock, it was the right thing to do.” – September 14, 2007

Terri Belkas is a Currency Strategist at FXCM.