With the FOMC’s next rate decision looming on October 31, the markets are anxiously wondering if the central bank will cut rates again. Given the Dow’s rapid ascent to fresh record highs, it appears that equity investors are betting the bank that they will indeed cut again. Nevertheless, it’s the US Dollar that stands to benefit the most if the FOMC decides to leave rates unchanged, as the currency recently hit fresh 15-year lows on a trade-weighted basis. While core inflation may have moderated, rising costs for volatile items such as food and energy create the risk of surging price pressures. As a result, the FOMC is in a precarious position: will they ignore inflation risks and move to support the US equity markets with a rate cut?

Over the course of last week, a spate of dour economic news led government bonds to work their way higher and sending long-term yields plummeting. Meanwhile, short-term yields slowly eased back, as traders bet that they would not encounter policy moves by any of the major central banks. In fact, despite broadly dismal fundamental data out of the US, the nation’s yield curve actually flattened out somewhat as investors started to bet that the FOMC will not be as aggressive in cutting rates during the month of October.

Looking ahead, government bond traders will be watching the ECB and BOE meetings on Thursday. While neither bank is expected to hike, any commentary from ECB President Trichet during his press conference signaling whether or not they will hike before year could send the fixed income, forex, and equity markets reeling. Meanwhile, the BOE does not typically issue policy statements after their meetings, but since they did during their September meeting, markets will be looking for a repeat as well as clues into the bank’s next move.

US Fed: One and Done?

With the FOMC’s next rate decision looming on October 31st, the markets are anxiously wondering if the central bank will cut rates again. Given the Dow’s rapid ascent to fresh record highs, it appears that equity investors are betting the bank that they will indeed cut again. Nevertheless, it’s the US Dollar that stands to benefit the most if the FOMC decides to leave rates unchanged, as the currency recently hit fresh 15-year lows on a trade-weighted basis. While core inflation may have moderated, rising costs for volatile items such as food and energy create the risk of surging price pressures. As a result, the FOMC is in a precarious position: will they ignore inflation risks and move to support the US equity markets with a rate cut?

Frederic Mishkin, Federal Reserve Board Governor (Voter)

“Inflation has come down in the old-fashioned way. Tighter monetary policy and a commitment to price stability by central banks throughout the world have led to lower inflation and an anchoring of inflation expectations.” – September 28, 2007

William Poole, Federal Reserve Bank of St. Louis President (Voter)

“There was going to be a surprise...no matter the way we did it. The only way to meet market expectations would have been a 14-basis-point cut…the markets should not bake into the cake more rate cuts.” – October 1, 2007

Charles Plosser, Federal Reserve Bank of Philadelphia President (Non-Voter)

“It is important to understand that the economy is expected to grow more slowly in coming months, despite last week's decision to reduce rates. Therefore, I will not be surprised to see weaker statistics making headlines…While inflationary signs this summer have been encouraging, I do not think we are in a position to be sanguine. The inflation risk is still there. Oil is still very high. Wage growth is still very high. Liquidity is still very high. And expectations are still very high. If inflation begins to creep up or expectations of future inflation rise in the coming months -- which is a risk given our decision to cut rates -- the outlook will be affected and policy may have to be adjusted.” – September 26, 2007

Alan Greenspan, Former Federal Reserve Chairman

“The danger of recession has obviously risen but in my judgment...is still less than 50/50. It's less optimistic than one would like.” – September 28, 2007

“I expect home price decline to continue until the rate of inventory liquidation reaches its peak. The recent decline in house prices are already eating into home equity and consumer spending and gross domestic product will be under pressures from household wealth.” – October 1, 2007

ECB: With EUR/USD Above 1.40, Can the ECB Afford to Hike?

The European Central Bank has taken a lot of flak for their aggressive monetary policy stance as EUR/USD continues to breach new record highs. Commentary from members of the ECB is starting to sound defensive, while officials outside of the central bank have made meager attempts to jawbone the currency. Nevertheless, it has become clear that there is very little room for the ECB to tighten policy further. On the weekend of October 19th the next G7 meeting will take place, and given the rapid appreciation of the Euro, finance ministers from the Euro-zone may take the opportunity to talk the currency down:

Jean-Claude Trichet, European Central Bank President

“The ECB and the Euro system took the appropriate decisions to help ensuring the orderly functioning of the money market.” – October 1, 2007

Miguel Angel Fernandez Ordonez, European Central Bank Governing Council Member

“Since August, one of the few pieces of data available are confidence surveys, although generally these don't show substantial changes. As a result, it would be premature to attempt to precisely evaluate the foreseeable impact of the turbulence on world economic growth.” – September 27, 2007

Jean-Claude Juncker, Euro Group President

“The strong Euro, as long as it stays on its path, tends to worry us a lot.” – October 2, 2007

Michael Glos, German Economy Minister

“The strong increase of the Euro against the dollar worries me and I hope it won't continue this way.” – September 26, 2007

Richard Lee is a Currency Strategist at FXCM.