Many Federal Open Market Committee members have made a point of signaling some hesitance to cut rates again in the near-term, as a weaker US dollar and record high oil prices significantly raise inflation risks in the economy. However, traders appear to be trying to force the bank’s hand as federal fund futures currently price in a 98 percent chance of a 25bp rate cut in December. These markets could get an unwanted surprise if futures continue to price in such policy action but the FOMC actually leaves rate steady. With less than a month until Bernanke & Co. convene again, can they convince the markets that they don’t need to make policy more accomodative?

Yield Spread Analysis 11/06 – 11/13

Flight-to-safety took a hold of government bond markets over the past week amidst broad weakness in global equities. Bonds with longer term maturities saw their yields drop the most, with 10-year Treasuries, Canadian Government Bonds, Australian Government Bonds, and Gilts all down more than 10bp. Indeed, this came even as the Reserve Bank of Australia hiked interest rates – which typically drives yields higher – and as the European Central Bank offered a hawkish tone following their policy meeting. As long as stock markets like the Dow, FTSE 100, and Nikkei continue to take a hit, government bonds are likely to move higher, sending yield spiraling lower. However, this may also lead to some mis-pricing of interest rate cut possibilities. Fed fund futures currently price in a 98 percent chance of a 25bp cut in December, and given recent commentary from some FOMC members, this may be unrealistic and could increase price risks for the equity markets ahead of the actual meeting.

US Fed: Inflation Very Likely To Prevent A 25bp Cut in December

Many Federal Open Market Committee members have made a point of signaling some hesitance to cut rates again in the near-term, as a weaker US dollar and record high oil prices significantly raise inflation risks in the economy. However, traders appear to be trying to force the bank’s hand as federal fund futures currently price in a 98 percent chance of a 25bp rate cut in December. These markets could get an unwanted surprise if futures continue to price in such policy action but the FOMC actually leaves rate steady. With less than a month until Bernanke & Co. convene again, can they convince the markets that they don’t have to make policy more accomodative?

Ben Bernanke, Federal Reserve Chairman (Voting Member)

“Core inflation has improved modestly, although recent increases in energy prices will likely lead overall inflation to rise for a time.” – November 8, 2007

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

“It could be that the downdraft from the housing industry will spread to other sectors, which might require that recent rate cuts not be reversed, or even that additional cuts would be in order…The loss of wealth associated with the decline in housing prices, as well as the fact that mortgage payments will absorb a larger portion of disposable income for some consumers, might cause consumption -- the largest component of GDP -- to grow at a significantly slower rate.” – November 8, 2007

Charles Plosser, Federal Reserve Bank of Philadelphia President (Alternate Voting Member)

Told the New York Times that he “would not be surprised” if fourth-quarter growth was 1 percent to 1.5 percent, which he says is “already built into my forecast. The key here is that growth would have to be less than the forecast to cut rates again.” In regards to the October 31st rate cut, he notes, “I happen to think this decision was a close call.” – November 6, 2007

Dennis Lockhart, Federal Reserve Bank of Atlanta President (Non-Voting Member)

“The conventional wisdom is that continued depreciation of the US dollar should have some effect on inflation,” but “the pass-through is not automatic.” – November 8, 2007

BOJ: No Rate Normalization Until 2008

For the sixth straight meeting, Atsushi Mizuno was the sole monetary policy committee member at the Bank of Japan to advocate a rate hike. Nevertheless, with the economy still in deflation and expansion growing very slowly, rate normalization in Japan may do more harm than good. The overnight lending rate is by far the lowest amongst the industrialized nations, and with this figure unlikely to change anytime soon. As a result, the sole driver of Japanese yen strength will remain risk aversion:

The Bank of Japan’s Monthly Report

“Japan's economy is expected to continue expanding moderately… Domestic corporate goods prices are likely to continue increasing for the time being, primarily reflecting the rise in international commodity prices. The year-on-year rate of change in consumer prices is expected to be around zero percent in the short run. From a longer-term perspective, however, it is projected to continue to follow a positive trend, as the output gap continues to be positive.” – November 13, 2007

Yasuo Fukuda, Japanese Prime Minister

“The yen is appreciating too fast…In the short term, yen appreciation would certainly be a problem. Any kind of sudden change in exchange rates would not be desirable…Speculative movements need to be kept in check. What I am saying is: Be careful, so that it [intervention] will not happen.” – November 13, 2007

Hiroko Ota, Japanese Economics Minister

In noting risk factors facing the economy, she notes, “One is how the subprime problems will affect the US economy, especially US consumption, and then how that would affect the Japanese economy…One important point to look at is how long the yen’s current strength will continue. If that is sustained, there will be an impact on corporate earnings.” – November 13, 2007

“High oil prices haven't affected the Japanese economy...Neither have recent volatile moves in Japanese stocks and other financial markets so far. But I will continue monitoring these things closely.” – November 9, 2007

Richard Lee is a Currency Strategist at FXCM.