After announcing multiple new lending facilities over the past few weeks in an attempt to avert a credit crunch, the Federal Reserve turned their attention to the economy. With the downside risks to growth mounting significantly – suggesting the US economy is in or nearing a recession – it is not surprising to see that the Fed cut rates on Tuesday. What was surprising was that they opted to reduce the fed funds rate by 75bps, rather than the 100bp cut futures were pricing in yesterday. Indeed, the US dollar initially strengthened on the announcement while the US stock markets pulled back, especially as two FOMC members – Fisher and Plosser – voted in favor of “less aggressive action.” Going forward, it appears that the Federal Reserve will continue to try to target liquidity issues with new and existing lending facilities, while attempting to balance the slowing US economy with rising energy and food prices via the fed funds rate.

Yield Spread Analysis 03/11 – 03/18

After the news that JP Morgan would buy Bear Stearns for $2 per share on Sunday, global yields plunged as risk aversion gripped the markets. However, traders became more confident on Tuesday, especially after the Federal Reserve cut rates by 75bps, which actually led yields to bounce from Monday’s lows. Much of the reaction was due to the fact that many were expecting a more drastic 100bp cut, and with two FOMC members signaling that they were concerned about inflation, the policy announcement was even more surprising.

However, looking ahead, the threat of a return to risk aversion looms large, as the woes of the financial sector are far from over. Nevertheless, as we’ve seen in the past, traders can become bullish even after the most bearish declines (especially in the stock markets). Meanwhile, the release of the minutes from the BOE’s March MPC meeting could shake up UK bonds, especially if there was more than one vote for a rate cut.

US Fed: 75bp Cut Shows That Economy, Financial Markets Remain Core Focus but Inflation Concerns are Building

After announcing multiple new lending facilities over the past few weeks in an attempt to avert a credit crunch, the Federal Reserve turned their attention to the economy. With the downside risks to growth mounting significantly – suggesting the US economy is in or nearing a recession – it is not surprising to see that the Fed cut rates on Tuesday. What was surprising was that they opted to reduce the fed funds rate by 75bps, rather than the 100bp cut futures were pricing in yesterday. Indeed, the US dollar initially strengthened on the announcement while the US stock markets pulled back, especially as two FOMC members – Fisher and Plosser – voted in favor of “less aggressive action.” Going forward, it appears that the Federal Reserve will continue to try to target liquidity issues with new and existing lending facilities, while attempting to balance the slowing US economy with rising energy and food prices via the fed funds rate.

Federal Open Market Committee Statement

“Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability.” – March 18, 2008

Henry Paulson, US Treasury Secretary

“What's important is we know we're in a sharp (decline), and there's no doubt that the American people know that the economy has turned down sharply.” – March 18, 2008

“The objective here is to get the balance right -- regulation needs to catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient or cut off credit to those who need it.” – March 14, 2008

ECB: All Bark and No Bite When It Comes to the Euro

Despite some tough talk from ECB President Trichet regarding exchange rates, the Euro ascended to record highs over the course of the past week, as the combination of a staunchly hawkish inflation stance along with an ultra-dovish Federal Reserve has given traders every reason in the world to pile into EUR/USD long positions. However, with the US central bank taking a more inflation-centric stance themselves on March 18, any indications that the ECB may address their own downside risks to growth with a rate cut in the near-term could lead the currency to plummet:

Jean-Claude Trichet, European Central Bank President

“On the foreign exchange, especially with the dollar, I reaffirm that the disorderly movements of exchange rates are undesirable from the point of view of economic growth. In the present circumstances, I am preoccupied with the excessive foreign exchange movements.” – March 13, 2008

Juergen Stark, European Central Bank Executive Board Member

“Monetary policy is not the appropriate tool for managing the short-term costs of structural reforms or for providing incentives for reforms at the national levels.” – March 17, 2008

“The ECB is alarmed by inflation developments and it is not willing to tolerate second-round effects.” – March 13, 2008

Erkki Liikanen, European Central Bank Executive Board Member

“Price stability in the medium term is a requisite for sustainable employment and growth of the economy. Without it growth can't be upheld. The idea is that people and companies shouldn't have to consider inflation risk when taking decisions, but to assume it to be insignificant.” – March 17, 2008

Jean-Claude Juncker, Euro Group President

“I don't see any element which could let me conclude we are facing a recession. We will have economic growth in the course of this year slightly below our growth potential.” – March 12, 2008

Richard Lee is a Currency Strategist at FXCM.