Strong inflation pressures have thus far left the European Central Bank maintaining a hawkish bias. However, downside risks to growth, instability in the financial markets, and the rapid appreciation of the Euro has also left the bank quite unsure of what to do next. As the ECB ponders whether more accommodative policy is necessary, Trichet will likely be awaiting the US Fed’s next move, as a rate cut by Bernanke in the face of percolating inflation will give the ECB the green light to consider cutting as well.

Yield Spread Analysis 11/20 – 11/27

By and large, flight-to-safety remains the primary driver of government bond markets – as has been the case for weeks on end – amidst broad weakness in global equities. Bonds with longer term maturities saw their yields drop the most, with 10-year Treasuries and Canadian Government Bonds down more than 10bp. Indeed, the shifts have not been entirely surprising in these regions given signs that the US economy continues to deteriorate, which could impact the Canadian economy as well given the trade ties between the two countries. Furthermore, Canadian inflation and retail sales data both declined upon release last week, giving the Bank of Canada the green light to consider cutting rates on December 4.

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. For example, Fed fund futures are fully pricing in a 25bp cut in December, and as we said last week, “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.” As a result, spikes in volatility – rather than fundamentals – will likely fuel price action in FX, fixed income, and equity markets in coming weeks.

ECB: Waiting For the US Fed to Make a Move?

Strong inflation pressures have thus far left the European Central Bank maintaining a hawkish bias. However, downside risks to growth, instability in the financial markets, and the rapid appreciation of the Euro has also left the bank quite unsure of what to do next. As the ECB ponders whether more accommodative policy is necessary Trichet will likely be awaiting the US Fed’s next move, as a rate cut by Bernanke in the face of percolating inflation will give the ECB the green light to consider cutting as well:

Jean-Claude Trichet, European Central Bank President

“Structured credit markets are exposed to valuation problems, which make the market very vulnerable to a shift in investor sentiment.” – November 23, 2007

Lucas Papademos, European Central Bank Vice-President

“The current conjuncture seems to point to an uncomfortable, though temporary, combination of higher inflation and somewhat slower economic growth in the coming months.” – November 26, 2007

Juergen Stark, European Central Bank Executive Board Member

“The ECB governing council has determined early in November that the risks for continuing economic growth in the Euro area have become possibly bigger. This estimate is still valid…We are seeing weaker growth in the US but in Europe the economic development in the third quarter was very positive.” – November 26, 2007

Axel Weber, European Central Bank Governing Member

“For the Euro area all of our interest rate decisions were warranted to maintain our primary objective of price stability. Clearly our objective was the main motivation behind (recent decisions) our policy decision was vindicated.” – November 23 2007

Guy Quaden, European Central Bank Governing Council Member

“The strong Euro is a result of the weak US Dollar. Economic activity in the United States is slowing and the country has large deficits on its external accounts. The European currency has already provided its contribution…The Federal Reserve has already reduced interest rates in the past months, but at 4.5 percent it is still a half point higher than in Europe. The European Central Bank is in a wait and see mode for the moment.” – November 26, 2007

Christian Noyer, European Central Bank Governing Council Member

“Current estimates put the direct cost of subprime defaults at around $250 billion. It is significant but bearable, especially starting from a point of very favorable economic conditions and high profitability.” – November 27, 2007

BOE: Can Inflation Hawks Keep the Doves at Bay?

Now that is has been revealed that the Bank of England’s decision to leave rates steady in November was a 7-2 vote – with Gieve and Blanchflower dissenting in favor of a cut – it is clear that dovish sentiment within the monetary policy committee is growing. The bank’s Chief Economist remains hawkish, but Deputy Governor Lomax appears to be turning in favor of more accommodative policy. With credit conditions continuing to tighten and UK equities taking a hit, BOE Governor Mervyn King may have a tough time keeping the majority in favor of leaving rates steady on December 6:

Charles Bean, Bank of England Chief Economist

“The backdrop to our attempts to keep inflation in line with target is less favorable than it has been…If the imported component of inflation is somewhat higher, the domestically generated component needs to be somewhat lower to compensate, and that may mean we have to run a tighter monetary policy for a while to get that domestic inflation down.” – November 26, 2007

Rachel Lomax, Bank of England Deputy Governor

“There are always risks in signaling that policy will be eased at a time of rising energy prices. This is all the more so after a year when inflation has been above target and on some measures remains uncomfortably high. On the other hand, we need to be very alert to the risk that the economy may be slowing too abruptly. At current interest rate levels monetary policy may be on the restrictive side.” – November 23, 2007

“The duration and impact of financial turbulence is very hard to call. There must be a risk that at some stage it will spill over into asset and property markets more generally and trigger a damaging loss of confidence…The MPC faces a tricky period as we try to weigh the risk of an unduly sharp downturn against the threat to inflation posed by a sharp surge in global energy prices. Much will depend on developments in the rest of the world." – November 23, 2007

Richard Lee is a Currency Strategist at FXCM.