Last Tuesday, the Federal Reserve enacted an emergency 75bp rate cut as US stock market futures tumbled. Some saw the move as a complete panic reaction, and the central bank has essentially established that it will respond to the cries of the equity markets, despite the fact that monetary policy is intended to be used for the “pursuit of maximum employment, stable prices, and moderate long-term interest rates.” The big question now is: does the Fed follow the markets, or do the markets follow the Fed? Futures are pricing in an 86 percent chance of a 50bp cut to 3.00 percent on Wednesday, but what if traders are wrong? FOMC member Poole voted against the policy action last week, signaling that everyone may not be on board to aggressively cut rates. The impact of an unexpected decision on the markets - and especially the US Dollar - would be severe, but with the Fed clearly averse to stoking volatility it appears they will likely do as futures dictate.

Yield Spread Analysis 01/22 – 01/29

Over the course of the past week, yields on global government bonds have generally risen as the Federal Reserve’s emergency rate cut on January 22 helped spur a rebound in stock markets around the world. However, short-term yields on the US continue to pull lower as the markets aggressively price in another rate cut of up to 50bp on January 30. Meanwhile, short-term yields in the Euro-zone remain elevated as ECB President Trichet’s resoundingly hawkish commentary leaves traders confident that the bank has no intention of cutting rates Fed-style anytime soon. Likewise, UK fixed income traders have started to judge that the markets may have been too aggressive in pricing in another round of rate cuts by the Bank of England, which has gone on to help elevate the British Pound across the majors

As we mentioned, futures are pricing in a 50bp rate cut by the Federal Reserve this week, which provides substantial event risk for global fixed income, FX, and equity markets. Indeed, if the central bank opts to take the road less traveled and leaves rates steady, the news could trigger a huge bout of risk aversion, leading carry trades to unwind further. On the other hand, if Bernanke & Co. move to placate the markets, stocks will likely stage another relief rally while the US Dollar may weaken even more.

US Fed: Will Bernanke Feed the Markets Another Dose of Rate Cuts?

Last Tuesday, the Federal Reserve enacted an emergency 75bp rate cut as US stock market futures tumbled. Some saw the move as a complete panic reaction, and the central bank has essentially established that it will respond to the cries of the equity markets, despite the fact that monetary policy is intended to be used for the “pursuit of maximum employment, stable prices, and moderate long-term interest rates.” True, the Fed is also charged with maintaining the stability of “the financial system and containing systemic risk that may arise in financial markets.” Nevertheless, declines in the equity markets have thus far been orderly, suggesting that a reduction in the overnight lending rate was unnecessary just a week ahead of a scheduled FOMC meeting. The big question now is: does the Fed follow the markets, or do the markets follow the Fed? Futures are pricing in an 86 percent chance of a 50bp cut to 3.00 percent on Wednesday, but what if traders are wrong? FOMC member Poole voted against the policy action last week, signaling that everyone may not be on board to aggressively cut rates. The impact of an unexpected decision on the markets - and especially the US Dollar - would be severe, but with the Fed clearly averse to stoking volatility it appears they will likely do as futures dictate.

FOMC Policy Statement

"The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3-1/2 percent.

The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks…Voting against was William Poole, who did not believe that current conditions justified policy action before the regularly scheduled meeting next week." – January 22, 2008

Alan Greenspan, Former Federal Reserve Chairman

“The probability of recession is probably 50 percent or maybe slightly more, but we're not there yet.” – January 25, 2008

ECB: Trichet Refuses To Back Away From Hawkish Stance

The European Central Bank has remained united in their hawkish rhetoric, as ECB President Jean-Claude Trichet makes it very clear that their focus remains on one thing, and one thing only: inflation. Indeed, price stability is the ECB’s primary mandate and until CPI falls back from current levels of 3.1 percent towards the bank’s 2 percent ceiling, the bank is not likely to even consider cutting interest rates.

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Jean-Claude Trichet, European Central Bank President

“There is one needle in our compass, which is price stability.” – January 25, 2008

Axel Weber, European Central Bank Governing Council Member

“If there is broad political support for wage claims that don't conform to price stability, this could require additional monetary policy action.” – January 25, 2008

Juergen Stark, European Central Bank Executive Board Member

“I am not happy with current inflation of more than 3 percent, but it is probably temporary. It is crucial that inflationary expectations remain well anchored.” – January 25, 2008

Nevertheless, Trichet faces some clear opposition in the Euro-zone regarding monetary policy amidst instability in the financial markets and growing downside risks to growth, but as one to assert the ECB’s independence, he is highly unlikely to take note:

Christoph Leitl, Austrian Federal Economic Chamber President

“ECB president Jean-Claude Trichet is making sure that everything is okay on the stability front. That's good. Trichet is sitting up in his box. I want him to come down from there and go up on stage and take an active role. Reality says that if the Americans can cut their rates by three quarters of a percentage point, then we Europeans should cut ours by a half-point, if only to give the right signals.” – January 24, 2008

Pedro Solbes, Spanish Finance Minister

“I think it wouldn't be logical for the ECB to raise interest rates at the moment, and if there is any movement (in rates), it would be logical for it to be down.” ¬– January 24, 2008

BOE: Is Mervyn King Trying To Pull a “Trichet”?

Less than a month ago, deteriorating economic conditions in the UK along with relatively subdued inflation figures (compared to the Euro-zone and the US) led us to believe that after the Bank of England’s December rate cut, there would be more to come in the near future. Indeed, BOE MPC members like über-dove Blanchflower make it sound like rates can’t be cut quickly enough. However, BOE Governor Mervyn King has been sounding more like ECB President Jean-Claude Trichet lately given his hawkish rhetoric, and if the UK central bank continues to sound the alarm on inflation expectations, the markets will move to price in neutral policy action through the first half of this year, which will be to benefit the British Pound.

Do you follow the Cable pair daily? Visit the British Pound Currency Room for resources dedicated specifically to Sterling.

Bank of England MPC Meeting Minutes from January 9-10

“For most members, no change in Bank Rate was necessary this month…a second period during which inflation was significantly above target so soon after the one in Spring 2007, might be more likely to lead people to revise up their expectations of future inflation.” – Released on January 23, 2008

Mervyn King, Bank of England Governor

“It is possible that inflation could rise to the level at which I would need to write an open letter of explanation, possibly more than one to the Chancellor.” – January 23, 2008

Andrew Sentance, Bank of England Monetary Policy Committee Member

“It seems that expectations have been driven by a lot of news or fears on the real economy side and the financial markets but we've also had a lot of news on the inflation side as well and it's important that people factor in both sides of the equation.” – January 24, 2008

David Blanchflower, Bank of England Monetary Policy Committee Member

“Interest rates are restrictive at their current levels and that is why I have been voting for cuts. The evidence from the housing market, and especially the commercial property market, is worrying. Consumer confidence is low in the UK.” – January 28, 2008

“Worrying about inflation at this time seems like fiddling when Rome burns…I believe that there are risks to the upside to inflation but the greater risks are to activity on the downside.” – January 28, 2008

Richard Lee is a Currency Strategist at FXCM.