US economic data has not fared well as we enter 2008, as last week’s dismal non-farm payrolls reading of 18K and jump in the unemployment rate to a two-year high of 5.00 percent points toward a gloomy scenario: a consumer driven recession. Indeed, the US housing market is still in shambles, oil has touched a record of $100/bbl, and equity markets remain vulnerable. As the Federal Government discusses possible options for “economic stimulus” packages in this all-important election year, there is little doubt the FOMC will move to make monetary policy more accommodative this month. The question is, will it be a 25 or 50bp cut? Fed fund futures are betting on a 68 percent chance of the latter, but if next week’s CPI figures surge – suggesting inflation pressures are steadily building – the markets may move back to pricing in a 25bp cut. Either way, upcoming releases could spark major volatility for the US Dollar, especially as we near the big rate announcement on January 30.

Yield Spread Analysis 01/02 – 01/08

A spike in risk aversion and sharp declines in the equity markets sent government bonds surging amidst flight-to-safety, subsequently sending yields tumbling. The greatest shift was seen in the US, with 10-year Treasury yields plunging more than 16bp as recession risks mount. Indeed, US NFPs proved to be disappointing while the unemployment rate ticked up to a two-year high of 5.0 percent, and as a result, fed fund futures have moved to price in at least a 25bp rate cut at the end of the month and a 68 percent chance of 50bp cut. US economic data released over the course ahead of the January 30th meeting may shake up these estimates, as Retail Sales and CPI will likely prove to be highly market moving next week.

Looking ahead, this week’s US data may do little to spark major volatility, but rate decisions on Thursday by the Bank of England and the European Central Bank will be watched carefully, though neither is expected to adjust interest rates. Meanwhile, 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: It’s Not A Matter of If They Will Cut, But By How Much

US economic data has not fared well as we enter 2008, as last week’s dismal non-farm payrolls reading of 18K and jump in the unemployment rate to a two-year high of 5.00 percent points toward a gloomy scenario: a consumer driven recession. Indeed, the US housing market is still in shambles, oil has touched a record of $100/bbl, and equity markets remain vulnerable. As the Federal Government discusses possible options for “economic stimulus” packages in this all-important election year, there is little doubt the FOMC will move to make monetary policy more accommodative this month. The question is, will it be a 25 or 50bp cut? Fed fund futures are betting on a 68 percent chance of the latter, but if next week’s CPI figures surge – suggesting inflation pressures are steadily building – the markets may move back to pricing in a 25bp cut. Either way, upcoming releases could spark major volatility for the US Dollar, especially as we near the big rate announcement on January 30.

FOMC Meeting Minutes From December 11, 2007

“…participants agreed that the housing correction was likely to be both deeper and more prolonged than they had anticipated in October…. Participants recognized, however, that uncertainties about values of mortgage-related assets and related losses, and consequently strains in financial markets, could persist for quite some time… Members also recognized that financial market conditions might improve more rapidly than members expected, in which case a reversal of some of the rate cuts might become appropriate.” – January 2, 2008

“With futures prices pointing to a gradual decline in oil prices...participants generally continued to see core PCE inflation as likely to trend down a bit over the next few years...and headline inflation as likely to slow more substantially from its currently elevated level.” – January 2, 2008

Donald Kohn, Federal Reserve Vice Chairman (Voting Member)

“The resulting dispersion of messages has bothered market participants seeking clear, unambiguous guidance about the views of the central bank…The public should understand that the FOMC members do not coordinate schedules and messages, and that members' views are likely to be especially diverse when, as in the current situation, circumstances are changing quickly and are subject to many different analyses. The diversity of views on the committee is one of its strengths and vital to arriving at sound decisions…When, as now, the FOMC believes that uncertainty is high, it may need to give greater weight to new information and be readier to revise its forecasts. Policy decisions may also take into account the substantial risk that the economy will turn out differently than the most likely forecast, especially when that alternative is seen as having unusually large costs.” – January 6, 2008

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

“The negatives in our economy may be gaining momentum…I think these circumstances call for policy-makers to be prepared to respond pragmatically to whatever developments arise…I'm concerned about inflation ... but I'm equally or more concerned about…mounting slowness.” – January 7, 2008

ECB: There’s No Deterring These Hawks

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? Credit markets have recently improved, which eliminates some of the urgent need to make conditions more accommodative, and until CPI starts to back off in the Euro-zone, the ECB is not likely to even consider cutting interest rates.

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

“The ECB’s Governing Council stands ready to counter upside risks to price stability…For the recent increase in inflation to remain temporary, it is essential that the price- and wage-setting behavior remains unaffected by current inflation rates.” – January 6, 2008

“We see growth continuing at a pace which is quite robust, even if there is a little bit of a slowing down.” – January 7, 2008

Regarding the spike in oil, food and other commodity prices…“There is a danger of second-round effects…and the risk of inflation spiraling is an important risk calling for no complacency.” – January 7, 2008

Athanasios Orphanides, European Central Bank Council Member

“Just because the ECB Governing Council waited for the turn of the year does not mean that it should not be ready to raise interest rates further if that was necessary.” – January 2, 2008

Richard Lee is a Currency Strategist at FXCM.