Following the FOMC’s 25bp cut on December 11th, the committee’s policy statement made a point of keeping all options open when it comes to the next meeting in January. Indeed, by noting upside inflation risks countered by downside risks to growth and uncertainty in the financial markets, Bernanke & Co. could do just about anything next month. However, with the Fed joining forces with the ECB, the BOE, the BOC, and the SNB in an effort to boost liquidity, the US central bank’s next policy move will likely depend primarily on if the lending facilities actually help ease the pressures in the credit markets. Until then, investors have little choice but to simply wait and see, though fears that stagflation will plague the US economy may keep speculation of another rate cut in January high.

Yield Spread Analysis 12/11 – 12/18

The mixture of a rate cut by the Federal Reserve on December 11th, an announcement on December 12th that the Fed, ECB, BOE, BOC, and SNB would make a coordinated effort to boost liquidity, and sharp declines in equities throughout the week have impacted global yield curves in very different ways. The most significant moves came on Friday when long-term yields in the US and Europe rocketed higher, as hot inflation data for both regions suggested that the Fed and ECB may not be in a rush to cut rates in January. Meanwhile, long-term rates in Switzerland actually eased back after the SNB left rates steady. While the decision was in line with expectations, there was some speculation that the bank would move to normalize rates given the risk of import price inflation.

Looking ahead to this week, Canadian bonds could be impacted by CPI figures on Tuesday, especially if they are surprisingly weak or strong. However, the biggest event risk remains the status of risk aversion, as massive flight-to-safety will most likely to support Treasuries, which have managed to remain a safe-haven investment.

US Fed: Keeping All Options Open As Stagflation Concerns Loom Large

Following the FOMC’s 25bp cut on December 11th, the committee’s policy statement made a point of keeping all options open when it comes to the next meeting in January. Indeed, by noting upside inflation risks countered by downside risks to growth and uncertainty in the financial markets, Bernanke & Co. could do just about anything next month. However, with the Fed joining forces with the ECB, the BOE, the BOC, and the SNB in an effort to boost liquidity, the US central bank’s next policy move will likely depend primarily on if the lending facilities actually help ease the pressures in the credit markets. Until then, investors have little choice but to simply wait and see, though fears that stagflation will plague the US economy may keep speculation of another rate cut in January high.

Will consumption growth collapse and raise the chances of recession? Join us in our discussion in the DailyFX Fed Watch Forum.

FOMC Monetary Policy Statement

“Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks…the Committee judges that some inflation risks remain…Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation.” – December 11, 2007
Charles Plosser, Federal Reserve of Philadelphia President (Alternate-Voting Member)

“The problem with the recent data, including the CPI and PPI, is that the price increases are becoming more broad-based. Thus it is becoming harder to view the increases as isolated relative price shocks that will dissipate over time. While not all the increases are big, they are showing up in more things. The more widespread are the price increases, the more it begins to suggest there are underlying inflationary pressures out there.” – December 17, 2007
Timothy Geithner, Federal Reserve Vice Chairman (Voting Member)

“The central aim of the new North American and European central banks' cooperative liquidity program is to reduce the incentive for an excessive liquidity hoarding by banks.” – December 13, 2007
Alan Greenspan, Former Federal Reserve Chairman

“We are beginning to get not stagflation, but the early symptoms of it…Fundamentally, inflation must be suppressed…It's critically important that the Federal Reserve is allowed politically to do what it has to do to suppress the inflation rates that I see emerging, not immediately, but clearly over the intermediate and longer-term period.” – December 17, 2007

ECB: Too Focused On Price Stability?

There is no doubt the European Central Bank remains hawkishly focused on price stability, despite the uncertainty surrounding the downside risks to growth and the reappraisal of risk in the financial markets that has led the Fed, the BOE, and the BOC to cut rates recently. Will this be to the detriment of the economy and the markets, or will Trichet and his fellow policy makers be remembered for keeping inflation in check? Clearly, the credit markets have been disrupted by ultra-tight conditions, but until CPI starts to back off in the Euro-zone, the ECB is not likely to come to the conclusion that monetary policy is too restrictive.

Has the Euro's rally come to an end as European data starts to disappoint? Check out what DailyFX analysts and other traders have to say about it in the DailyFX EUR/USD Forum.

Yves Mersch, European Central Bank Governing Council Member

“Euro-zone inflation is expected to stay high in 2008.” – December 14, 2007
Guy Quaden, European Central Bank Governing Council Member

“Prospects of higher inflation in the Euro-zone next year are a serious concern and the situation will be closely monitored.” – December 13, 2007

Jose Manuel Gonzalez-Paramo, European Central Bank Executive Board Member

“In our discussions we explore all possibilities, but at the end, the decision to leave rates unchanged was unanimous.” – December 12, 2007

Klaus Liebscher, European Central Bank Governing Council Member

“Despite (the) slowdown in the USA, (there is) still robust growth of the global economy.” – December 11, 2007

Nicholas Garganas, European Central Bank Governing Council Member

“Unemployment levels continue to be high, which presents serious social and economic problem.” – December 17, 2007

BOE: One and Done or More Cuts to Come?

Unlike the European Central Bank, the Bank of England opted to follow the lead of the Federal Reserve this month by cutting interest rates by 25bp, as tightening credit conditions put the UK central bank on edge. Nevertheless, many MPC members still remain concerned about inflation risks, suggesting that the December rate cut may have been more of a pre-emptive measure rather than the start of a cycle to make monetary policy more accommodative.

Nevertheless, traders in the DailyFX GBP/USD Forum are generally betting that more declines are in store for Cable. What do you think?

Rachel Lomax, Bank of England Deputy Governor

“Inflation came down, growth has been strong, it has only just started to exhibit signs of a slowdown. Things are not as bad as they are sometimes painted.” – December 14, 2007

Kate Barker, Bank of England Monetary Policy Committee Member

“Clearly there are a lot of risks around at the moment and in this region we have found the reflections of those risks are concerns about growth in the next year. There are concerns on the inflation front and concerns about growth falling away.” – December 14, 2007

“Manufacturing companies at the moment are doing quite well - sterling has weakened off a bit and that is good news for a lot of these companies…companies which have survived the difficulties of the past few years are generally in pretty good shape with good products and their optimism remains unchanged despite the difficulties we have been experiencing in the financial markets.” – December 14, 2007

Paul Tucker, Bank of England Monetary Policy Committee Member

“We must try to avoid a vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other. The announcement yesterday by central banks of coordinated action via term auctions to alleviate pressure in financing markets is directed at that.” – December 13, 2007

Richard Lee is a Currency Strategist at FXCM.