Federal Reserve Chairman Ben Bernanke’s ultra-dovish commentary last week triggered a major sell-off for the US Dollar and led fed fund futures to fully price in a 50bp cut on January 30, along with a 50 percent chance of a whopping 75bp cut (as of Monday’s close). We do not expect anything more than a 50bp cut, but the market’s expectations underpin the major losses for the greenback, and raise the probabilities that the beleaguered currency will hit record lows against the Euro once again.

Yield Spread Analysis 01/08 – 01/15

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 short-term yields in the US and Canada, as dovish commentary from Federal Reserve Chairman Ben Bernanke sent futures markets rushing to price in sharp rate cuts on January 30. In fact, fed fund futures are now fully pricing in a 50bp cut and a 50 percent chance of a more severe 75bp cut. With economic data rapidly deteriorating, the markets are increasingly ramping up speculation that the US has already entered recession. US economic data released ahead of the January 30th meeting may shake up these estimates, as Retail Sales and CPI will likely prove to be highly market moving this week. 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: Dovish Bernanke Suggests the Rate Cut Cycle Is Far From Over

Federal Reserve Chairman Ben Bernanke’s ultra-dovish commentary last week triggered a major sell-off for the US Dollar and led fed fund futures to fully price in a 50bp cut on January 30, along with a 50 percent chance of a whopping 75 bp cut (as of Monday’s close). We do not expect anything more than a 50bp cut, but the market’s expectations underpin the major losses for the greenback, and raise the probabilities that the beleaguered currency will hit record lows against the Euro once again.

Ben Bernanke, Federal Reserve Chairman (Voting Member)

“As you know, the Committee cut its target for the federal funds rate by…a percentage point from its level just before financial strains emerged. The Federal Reserve took these actions to help offset the restraint imposed by the tightening of credit conditions and the weakening of the housing market. However, in light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary…we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.” – January 10, 2008

Frederic Mishkin, Federal Reserve Board Governor (Voting Member)

“The easing of the stance of monetary policy in response to deteriorating financial conditions seems unlikely to have an adverse impact on the outlook for inflation.” – January 14, 2008

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

“The combined weakness in wealth -- that is both housing wealth and stock market wealth -- and some softness in employment growth seem to be suggesting that the robustness of consumer spending going forward may not be as healthy as we thought it was just a few months ago.” – January 14, 2008

“The economy is going to be weak; the real question is how much weaker it's going to get…I don't think we've overshot yet…there are risks to the downside of even weaker economic growth.” – January 8, 2008

Eric Rosengren, Federal Reserve Bank of Boston President (Voting Member)

“My view is that the continued decline in residential investment has heightened the risk of a more significant downturn in the overall economy. Falling housing prices further weaken the incentives for residential investment, but are also likely to dampen consumer and business confidence and spending.” – January 14, 2008

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

“Stable inflation expectations give the Federal Reserve a lot of room for maneuver…If the evidence suggests that substantial policy easing is appropriate, I don't think we're going to face a risk of adverse inflation expectation consequences.” – January 9, 2008

ECB: Trichet Remains Hawkish, Supporting Additional Euro Gains

While rhetoric from European Central Bank President Jean-Claude Trichet sounds unabashedly hawkish, commentary from other central bankers suggest some hesitance to make interest rates more restrictive. Indeed, continued instability in the markets and vulnerable credit conditions warrant some careful consideration, as the drawbacks of a sharp economic slowdown may outweigh the risks of persistent inflation pressures. Nevertheless, as we’ve discussed in the DailyFX Forums, the ECB’s primary mandate is price stability and until CPI falls back from current levels of 3.1 percent towards the bank’s 2 percent ceiling, Trichet is not likely to even consider cutting interest rates.

Jean-Claude Trichet, European Central Bank President

“In a context of very vigorous money and credit growth, our assessment of upside risks to price stability has been fully confirmed. The Governing Council remains prepared to act preemptively so that second-round effects and upside risks to price stability over the medium term do not materialize and, consequently...However, the ongoing reappraisal of risk in financial markets is still accompanied by uncertainty about its potential impact on the real economy and the risks surrounding the outlook for economic activity are on the downside. We will continue to monitor very closely all developments over the coming weeks.” – January 10, 2008

“Hence the period of temporarily high rates of inflation would be somewhat more protracted than previously expected.” – January 10, 2008

Lorenzo Bini Smaghi, European Central Bank Executive Committee Member

“Inflation rose in the last few months because of an increase in oil and agricultural prices, as well as a rise in Germany's VAT (value-added tax). This should be a temporary phenomenon. Inflation should go back below 2 percent by the end of the year. But on one condition: wages must not seek to catch up with prices to compensate for a weakening in purchasing power following this price rise.” – January 14, 2008

Klaus Liebscher, European Central Bank Governing Council Member

“Basic economic data for the Euro-zone remain at a healthy level, even if the uncertainty concerning the economy's further development and the risks associated with that is rising.” – January 14, 2008

BOJ: No Hope For Hikes In 2008, Risks Weighted Towards Rate Cut

The Bank of Japan’s most recent Regional Economic Report downgraded its core assessment of growth in the country, as four out of nine regions cut their individual outlooks. The news of sluggish growth prospects is particularly disappointing as the number of downgrades marks the largest amount since the central bank started issuing the report. Furthermore, policy makers and government officials alike are not pleased with the type of inflation they’re seeing, as it is purely the result of commodity cost gains rather than demand driven consumer price increases. Overall, the Bank of Japan is far more likely to cut rates this year, as a drop in energy and food costs will leave the economy dangerously close to deflationary conditions once again.

Nevertheless, the Japanese Yen has rallied signficantly recently. Discuss the currency with DailyFX analysts in the USD/JPY and GBP/JPY Forums.

Toshihiko Fukui, Bank of Japan Governor

“Rising raw material costs are making companies somewhat more cautious about business conditions…Economic growth is expected to slow for some time, although after that the economy will continue to gradually expand…The outlook for the global economy remains uncertain and downside risk to the US economy is growing. We must continue to pay great attention to the development of the global economy and capital and financial markets, and their impact on the Japanese economy.” – January 14, 2008

Toshiro Muto, Bank of Japan Deputy Governor

“The nation's economic cycle is weakening now but the cycle itself remains intact. Looking ahead, the economy will keep expanding in the future.” – January 10, 2008

Hiroko Ota, Japanese Economics Minister

“The various price rises, including for food, are starting to affect consumer sentiment bit by bit. I want to watch things very closely.” – January 14, 2008

Fukushiro Nukaga, Japanese Finance Minister

“As for monetary policy…we've even lowered our economic forecast for the ongoing fiscal year and we've also put together various measures (to prop up growth) in both the supplementary budget (for fiscal 2007) and the next fiscal year's budget. I would like to expect that the government and the Bank of Japan will work as one to underpin the economy and keep it on a growth path." – January 10, 2008

Richard Lee is a Currency Strategist at FXCM.