Entering the New Year, the US Dollar has started to weaken once again as economic data points towards the Federal Reserve’s worst fear: recession. Indeed, ISM Manufacturing plummeted below 50 to the lowest reading since April 2003, signaling contraction in the sector. As a result, fed fund futures have aggressively shifted to price in at least a 25bp rate cut on January 30, and a 26 percent chance of a 50bp cut from 0 percent just a few days ago. It remains to be seen whether the bank’s monetary policy adjustments will even make an impact, but it is clear that various FOMC members are concerned about inflation risks, which should make for some tough decision-making for the central bank this year. Nevertheless, the markets have consistently gotten it right since the FOMC started cutting rates last September, and this month is unlikely to be different.

Yield Spread Analysis 12/18 - 01/02

A spike in risk aversion ahead of the holidays sent government bonds surging amidst flight-to-safety, subsequently sending yields tumbling. The greatest shifts were seen in the UK, especially after the minutes from the Bank of England’s December meeting suggesting that more rate cuts may be on the way. Furthermore, data released for the country have generally highlighted deterioration in the economy, and with conditions in the UK only expected to get worse, yields may have further to fall which will likely take the British pound down with them. Meanwhile, 10-year Treasury yields have plunged more than 16bp as recession risks mount. Indeed, fed fund futures are currently pricing in at least a 25bp rate cut at the end of the month and a 26 percent chance of 50bp cut. Given the downside risks to growth in the US, yields will likely continue to trek lower in the near-term.

Looking ahead, Friday’s US non-farm payrolls release could shake up FOMC rate cut probabilities. However, the primary driver of fixed income market price action will likely remain risk aversion, so traders should keep an eye not only on economic data, but the status of the equity markets as well.

US Fed: Can Bernanke & Co. Save the Economy from Recession?

Entering the New Year, the US Dollar has started to weaken once again as economic data points towards the Federal Reserve’s worst fear: recession. Indeed, ISM Manufacturing plummeted below 50 to the lowest reading since April 2003, signaling contraction in the sector. As a result, fed fund futures have aggressively shifted to price in at least a 25bp rate cut on January 30, and a 24 percent chance of a 50bp cut from 0 percent just a few days ago. It remains to be seen whether the bank’s monetary policy adjustments will even make an impact, but it is clear that various FOMC members are concerned about inflation risks, which should make for some tough decision-making for the central bank this year. Nevertheless, the markets have consistently gotten it right since the FOMC started cutting rates last September, and this month is unlikely to be different.

Richard Fisher, President of the Federal Reserve Bank of Dallas (Alternate Voting Member)

“The actions we've taken should provide some buoyancy through the course of next year to the economy. But I want to make sure that we don't overreact and create further problems down the road … cutting rates, doing the things we've done, will facilitate economic growth next year from where it otherwise would have been. But I am also mindful of the fact that we've got some inflationary pressures building, and so we have to be careful that we don't stir those embers…The fed funds rate should be geared to the economy ... I don't know with precision what the time lags are, but I know there is a time lag, and it takes a while for it (policy action) to come into the economy. And that is why we have to be deliberate and think within the long-term context of what we do … I do not believe the fed funds rate is the palliative for solving immediate problems.” – December 19, 2007

Jeffrey Lacker, President of the Federal Reserve Bank of Richmond (Non-Voting Member)

“I have to say that I am uncomfortable with the inflation picture, and disappointed that the improvement we saw earlier this year was not more lasting.” – December 20, 2007

John Snow, Former Treasury Secretary

“The Fed has responded with a series of measured policy actions, but more will still need to be done to avoid a steep downturn, despite the most recent inflation reports…the problems in the housing sector and the seizing up of credit markets pose the risk of serious economic downturn; some even predict recession.” – December 27, 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.

How do you think this will impact the Euro? Check out what DailyFX analysts and other traders have to say about it in the DailyFX EUR/USD Forum.

Jean-Claude Trichet, European Central Bank President

“We are responsible for delivering price stability in line with our definition, in the medium term. And the sentiment of the Governing Council is that to deliver price stability in line with our definition, taking into account the risks that are upward, in this respect, it was necessary to maintain that level. And that’s the reason why we didn’t follow other colleagues, but the other colleagues are in a different situation. They see different things and their own analysis I respect.” – December 24, 2007

“As you know, the judgment of the governing council is that risks to price stability are on the upside… what is decisive are the second round effects. There we have the risk, and I was very clear that on behalf of the governing council, we would not let those second round effects materialize, and that we were alert to avoid those second round effects materializing.” – December 24, 2007

Klaus Liebscher, European Central Bank Governing Council Member

“I must maintain, the downside risks to growth projections have increased. Also the insecurity as to what effects the crisis will have on the real economy continues.” – December 19, 2007

“The ECB will do everything necessary so that the inflation rate falls below 2 percent again in the medium term. What is important is that such price shocks don't intensify in second-round effects in wages and prices.” – December 21, 2007

Vitor Constancio, European Central Bank Governing Council Member

“I have shown some preoccupation regarding risks to growth next year in the world economy…in other words, I am a little more pessimistic than a few months ago…it's not a dramatic scenario. The risks have in fact increased as a result of the crisis in the credit and monetary markets which was contrary to what was expected.” – December 21, 2007

Juergen Stark, European Central Bank Governing Council Member

“It may be that raw material prices in some regions don't develop as hoped. Then the upward inflationary pressure will remain a topic.” – December 28, 2007

BOE: More Cuts To Come

Unlike the European Central Bank, the Bank of England opted to follow the lead of the Federal Reserve by cutting interest rates, as tightening credit markets put the UK central bank on edge. Furthermore, economic conditions have already started to deteriorate and are anticipated to do so throughout 2008. With inflation looking relatively subdued compared to the Euro-zone and the US, there is a good chance the Bank of England will cut rates at least one more time this year.

Bank of England Monetary Policy Committee Meeting Minutes

“The worsening financial market turmoil, and the consequent tightening of credit conditions, had increased the downside risks to activity and inflation in the medium-term…signs of slowing growth were already apparent. That suggested a substantial loosening in policy might be needed. However, a large reduction in Bank Rate now would increase the upside risk to inflation…On balance, the Committee thought that the downside risks to the economy and inflation in the medium-term from the deterioration in financial market conditions outweighed the potential upside risks to inflation from short-run cost pressures.” – December 19, 2007

Mervyn King, Bank of England Governor

“The problems in the financial sector remain with us. A painful adjustment faces the global banking sector over the next few months as losses are revealed and new capital is raised to repaid bank balance sheets…Banks themselves have been worried that the impact of their reluctance to lend will lead to a sharper slowdown in the United States…that concern is a serious one because it does hold out the prospect that there will be a self-reinforcing downturn in credit and activity.” – December 18, 2007

David Blanchflower, Bank of England Monetary Policy Committee Member

“Wage pressure in the UK is benign and is likely to remain so. I take the view that there remains a considerable amount of slack in the UK economy in general and in the labor market in particular.” – December 24, 2007

Kate Barker, Bank of England Monetary Policy Committee Member

“If you look back to what we were expecting for the economy in November, we were talking about quite a sharp slowdown in growth but with some downside risks to that, partly around credit conditions. Credit conditions worsened in the markets as we went through November and early December so it looked as if some of those downside risks might be crystallizing, coming in to effect, and that was what really led us to cut rates.” – December 19, 2007

Richard Lee is a Currency Strategist at FXCM.