Comments by FOMC members ahead of the highly-anticipated October 31st rate decision shows some emerging divisions, as dovish references to softer core inflation have been countered by more neutral notations of healthy output and employment levels. Despite the fact that Fed fund futures are currently pricing in a 88% chance of a rate cut at the end of the month, the markets could see a surprising decision to leave policy unchanged as the FOMC may take a wait-and-see approach until December.

Yield Spread Analysis 10/16 – 10/23

A bout of risk aversion market-wide ahead of the G7 meeting sent government bonds surging higher, taking a toll specifically on long-term yields. In fact, nearly every country’s yield curve (that we follow) inverted further or at least moved to flatten. Some of the most dramatic action occurred in the US, as traders have increasingly been pricing in a 25 basis point rate cut by the Federal Reserve on October 31st. However, volatility could spike next week ahead of and after the actual rate announcement, as markets may not see the policy move that they are all expecting. Meanwhile, short-term debt in the UK has spiked higher since inflation figures proved to be softer-than-expected, which effectively reduced speculation that the Bank of England may take a hard-lined approach and possibly raise rates further. While we do not anticipate such a move on their part, we certainly do not foresee a rate cut by the central bank before year end either.

Given the fairly thin amount of economic data scheduled to be released this week, risk aversion trends will remain the primary driver of the fixed income markets.

US Fed: Will They Do The Unexpected And Leave Rates Unchanged?

Comments by FOMC members ahead of the highly-anticipated October 31st rate decision shows some emerging divisions, as dovish references to softer core inflation have been countered by more neutral notations of healthy output and employment levels. Despite the fact that Fed fund futures are currently pricing in a 88% chance of a rate cut at the end of the month, the markets could see a surprising decision to leave policy unchanged as the FOMC may take a wait-and-see approach until December:

Ben Bernanke, Federal Reserve Chairman (Voting Member)

“Uncertainty -- about the state of the economy, the economy's structure and the inferences that the public will draw from policy actions or economic developments -- is a pervasive feature of monetary policymaking.” – October 19, 2007

Sandra Pianalto, Federal Reserve Bank of Cleveland President (Alternate Voting Member)

“Since the Federal Reserve cut interest rates in September, the housing sector has remained very weak, but output and employment in other sectors appear to be holding up.” – October 19, 2007

Frederic Mishkin, Federal Reserve Board Governor (Voting Member)

“As long as the permanent change in relative energy prices does not lead to a change in the underlying trend rate of inflation - a crucial assumption - then headline inflation will come back down again … this is what we seem to have seen recently in the United States…What central bankers are truly concerned with ... is the underlying rate of inflation going forward, and core inflation can be a useful proxy for that rate … thus, focusing on core inflation can help prevent a central bank from responding too strongly to transitory movements in inflation.” – October 20, 2007

Thomas Hoenig, Federal Reserve Bank of Kansas City President (Voting Member)

“The question that one asks is what are the implications for policy and the answer to that is obvious and is wait and see. Because it depends on how all these factors play out…I'm optimistic, but I am also realistic and I want to stay alert as we move through this tender time.” – October 18, 2007

Randall Kroszner, Federal Reserve Governor (Voting Member)

“In the months ahead, the Federal Reserve will continue to monitor developments in the financial markets and act as needed to support the effective functioning of these markets and to foster sustainable economic growth and price stability.” – October 23, 2007

G7: Status Quo Statement Signals No Imminent Policy Changes

China bore the brunt of the G7 commentary, as finance ministers and central bankers aggressively tried to persuade the country to allow their currency to appreciate more quickly:

Lorenzo Bini Smaghi, European Central Bank Executive Committee Member

“The yuan has gained 10 percent against the dollar in two years. The message of this G7 is that the yuan must now appreciate also against the euro.” – October 22, 2007

Zhou Xiaochuan, People's Bank of China Governor

“China has no timetable for the full convertibility of the yuan.” – October 18, 2007

Given the rapid depreciation and vast weakness of the greenback, it’s no surprise that US Treasury Secretary Henry Paulson simply went with his “strong dollar policy” rhetoric:

Henry Paulson, US Treasury Secretary

“I was very clear and it didn't surprise anyone... that I believe a strong dollar is in our nation's interest, and believe that the currency value should be determined based upon underlying economic fundamentals in a competitive marketplace.” – October 22, 2007

Rodrigo Rato, International Monetary Fund Managing Director

“Up to now, movements in exchange rates have been orderly and in line with fundamentals. But there are risks that an abrupt fall in the dollar could either be triggered by, or itself trigger, a loss of confidence in dollar assets. And there is a risk that exchange rate appreciation in countries with flexible exchange rates - including the Euro area - could hurt their growth prospects, and that in these circumstances protectionist pressures could worsen.” – October 22, 2007

Weakness in the US dollar has played a large role in the Canadian dollar’s ascent to multi-decade highs, but it appears that the Bank of Canada has no intent to intervene:

Jim Flaherty, Canadian Finance Minister

“We face challenges adjusting to the rise of the Canadian dollar, which has borne the brunt of the US dollar adjustment.” – October 22, 2007

David Dodge, Bank of Canada Governor

“The recent rapid appreciation has been abnormally quick and doesn't seem to be related to the domestic factors which would normally have led to that sort of rapid appreciation. Our terms of trade have improved a little bit over the past three months but ... not a lot that would give that much impetus to things.” – October 22, 2007

Richard Lee is a Currency Strategist at FXCM.