The FOMC’s most recent decision to cut rates by 25bp to 4.50 percent was widely expected by the markets, but the accompanying policy statement suggested that rates will be left steady in December as the downside risks to growth are counterbalanced by upside inflation risks. However, the markets appear to be trying to take monetary policy into their own hands, as Fed fund futures are currently pricing in a 62 percent chance of another 25bp cut. So which will it be? It will likely depend very much on how the financial markets fare in coming weeks, especially as banks like Citigroup face massive losses from mortgage and debt-market problems.

Yield Spread Analysis 10/30 – 11/06

Global yield curve movements were mixed over the past week, but by far the biggest shift was seen in Canada. Significantly stronger-than-expected labor market figures sent short-term yields rocketing higher as the Canadian economy remains remarkably resilient despite the rapid appreciation of the Loonie. With employment conditions remaining tight domestic demand show few signs of letting up, which should prevent the Bank of Canada from even considering following the Federal Reserve’s lead and cutting rates. Meanwhile, short-term yields in the US continued to take a hit following the 25bp reduction in the Fed funds rate. However, the move is somewhat surprising since the policy statement suggested that they would not cut rates again in December. Nevertheless, the markets are fighting for another decrease in the overnight lending rate as debt-market concerns loom large, especially for big banks like Citigroup.

Looking ahead, Australian, UK, and European government bonds could see some wild price action as the RBA, BOE, and ECB are all scheduled to announce rate decisions this week. The RBA is the only bank anticipated to hike rates, leaving major upside potential for yields. However, hawkish rhetoric from ECB President Trichet could result in similar action for bund yields as well.

US Fed: On Hold From Now On? Not According To Fed Fund Futures

The FOMC’s most recent decision to cut rates by 25bp to 4.50 percent was widely expected by the markets, but the accompanying policy statement suggested that rates will be left steady in December as the downside risks to growth are counterbalanced by upside inflation risks. However, the markets appear to be trying to take monetary policy into their own hands, as Fed fund futures are currently pricing in a 62 percent chance of another 25bp cut. So which will it be? It will likely depend very much on how the financial markets fare in coming weeks, especially as banks like Citigroup face massive losses from mortgage and debt-market problems:

FOMC Statement

“Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time…the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully…after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.” – October 31, 2007

Randall Kroszner, Federal Reserve Governor (Voting Member)

“Looking ahead, two considerations suggest that conditions for subprime borrowers have the potential to get worse before they get better. First, all indications are that housing activity is continuing to weaken…. Second, the bulk of resets is yet to come: On average, in each quarter from now until the end of next year, monthly payments for more than 400,000 subprime mortgages are scheduled to undergo their first interest rate reset. That number is up from roughly 200,000 per quarter during the first half of 2007.” – November 5, 2007

Frederic Mishkin, Federal Reserve Board Governor (Voting Member)

“Going into the meeting, I was comforted by the lack of direct evidence to date of serious spillovers of the housing weakness and of tighter credit conditions on the broader economy. But with an unchanged policy interest rate, I saw downside risks to the outlook for growth…The FOMC perhaps could have waited for more clarity and left policy unchanged last week, but I believe that the potential costs of inaction outweighed the benefits, especially because, should the easing eventually appear to have been unnecessary, it could be removed.” – November 5, 2007

BOJ: Can Fukui Realistically Hike Before His Term Ends?

There is little doubt that Bank of Japan Governor Toshihiko Fukui is the biggest proponent of rate normalization in the economy, as he is responsible for putting an end to zero interest rate policy. However, with price growth still deflationary and economic expansion looking shaky amidst a slowdown in the US, Fukui may not realistically have the opportunity to raise rates any further than their current level of 0.50 percent before his term ends in March 2008:

Toshihiko Fukui, Bank of Japan Governor

“From a short-term point of view, downside risks related to the overseas economies and global financial markets seem to have increased somewhat and look set to be sustained. But from a longer point of view, if low interest rates that do not reflect economic fundamentals were left for too long, this may cause wild swings in financial and economic activity and result in a misallocation of resources.” – October 31, 2007

“As for the pace of (interest rate) increases, we will make them based on improvements in the economy and prices, without any forgone conclusions…Looking ahead, based on maintaining a virtuous cycle of production, income and spending, the probabilities are high that economy will continue a long-lived expansion.” – November 1, 2007

Hiroko Ota, Japanese Economics Minister

“I am concerned about declining housing investment and high oil prices…but I can't yet comment how the next gross domestic product reading will come out…we see downside risks to the economy with more emphasis…Japan's economy is recovering, but we need pay attention to the US economy.” – November 2, 2007

Fukushiro Nukaga, Japanese Finance Minister

“As the G7 statement said, the subprime issues will drag on for a while before they are resolved. I will keep monitoring their impact on stocks and foreign currencies…But as I have said repeatedly, the impact on the Japanese economy is limited and not serious.” – November 6, 2007

Richard Lee is a Currency Strategist at FXCM.