The European Central Bank has not backed off from their hawkish inflation bias by any means, and with good reason: CPI remains well above their comfort zone and upside inflation risks persist. However, there are mixed views on the impact of a US economic slowdown on the Euro-zone’s economies. Some ECB members remain optimistic, but most are leery of the potential for weak US export demand and a credit crunch to throw a wrench in the Euro-zone growth engine. Nevertheless, until CPI falls back markedly, the ECB will not even consider cutting rates, which should prevent EUR/USD from falling significantly lower.

Yield Spread Analysis 03/18 – 03/25

Despite an initial dip following the FOMC’s decision last Tuesday to cut the fed funds rate by 75bp to 2.25 percent, short-term yields have rocketed higher across the G-10 nations – with the exception of Australia and New Zealand – as the financial markets stabilize and risk aversion fades. Indeed, the yield on short-term US debt gained over 13bp, while yields in the UK and Canada are both up over 27bp. At the same time, stock markets around the world have bounced from multi-year lows, though it remains to be seen if these indexes can hold on to their gains. As we’ve seen in the past, it doesn’t take much to trigger sharp sell-offs of risky assets like equities or forex carry trades.

Looking ahead, FOMC members will likely remain mum on the economy, as they slowly put their expansion of lending facilities to work in order to stave off a more pronounced credit crunch. Meanwhile, upcoming economic data out of the US could shake up Treasuries if they prove to be very disappointing. Nevertheless, risk aversion trends remain the primary driver of the markets these days, so fixed income, forex, and equity traders should all keep an eye out for news from the financial sector.

ECB: Hawkish Inflation Bias Will Continue to Support EUR/USD

The European Central Bank has not backed off from their hawkish inflation bias by any means, and with good reason: CPI remains well above their comfort zone and upside inflation risks persist. However, there are mixed views on the impact of a US economic slowdown on the Euro-zone’s economies. Some ECB members remain optimistic, but most are leery of the potential for weak US export demand and a credit crunch to throw a wrench in the Euro-zone growth engine. Nevertheless, until CPI falls back markedly, the ECB will not even consider cutting rates, which should prevent EUR/USD from falling significantly lower in the near-term.

Axel Weber, European Central Bank Governing Council Member

“All financial market players are urged to disclose their risks. Uncertainties can only be removed by disclosing the extent of writedowns.” – March 19, 2008

“We expect that inflation rates will return towards our price stability norm in the medium term but risks are to the upside. We will do whatever is necessary and in our power to anchor the inflation rate and thereby inflation expectations below 2 percent in the medium term.” – March 19, 2008

Christian Noyer, European Central Bank Governing Council Member

“There is a clear upward bias to risks regarding inflation, which has to be taken into account by economic policy.” – March 19, 2008

Yves Mersch, European Central Bank Governing Council Member

“The crisis in the financial markets will certainly last longer than we were expecting. On the economic front, the downturn in the US housing market has provoked a slowing-down which is being felt more seriously than had been expected. From this point of view, the euro zone and the Luxembourgish economic will find it difficult to escape the impact of the easing of US demand.” – March 19, 2008

Jose Manuel Barroso, European Commission President

“From a European point of view, the euro zone economy is maintaining its extremely solid macro-economic basis. But it is not completely immune. We support all the efforts of the ECB and are watching how it is managing the situation, but we stress that it is completely independent in its decisions.” – March 18, 2008

BOE: Another Round of Rate Cuts May Loom for the UK in April

While inflation pressures are uncomfortably high for the Bank of England, the UK is facing a few conditions reminiscent of that of the US: the housing sector is slowing, consumer spending is deteriorating, and credit markets remain very tight. In fact, two Monetary Policy Committee (MPC) members voted for a 25bp rate cut at the BOE’s last meeting. If credit markets worsen ahead of the next MPC meeting in April, or if economic data signals that conditions are weakening more than expected, the BOE doves may not have trouble garnering a few more votes for a 25bp reduction to 5.00 percent in April.

Bank of England MPC Meeting Minutes

“Back-to-back reductions might lead observers to think that the Committee was focusing on downside risks to demand at the expense of the medium-term outlook for inflation…that in turn could lead to an exaggerated response of the market yield curve to a rate reduction.” – Released on March 19, 2008

Kate Barker, Bank of England Monetary Policy Committee Member

“We may see prices fall this year, but because of credit conditions, affordability will probably not improve at all…We’ll see residential construction fall this year, possibly quite significantly.” – March 21, 2008

Gordon Brown, UK Prime Minister

“We will maintain a policy that will keep inflation low and keep interest rates down. We've got a problem because we've seen oil, gas, and coal prices go up. We've also seen bad harvests in places put pressure on food prices. We're not complacent.” – March 25, 2008

Alistair Darling, UK Chancellor of the Exchequer

“Our economy remains fundamentally strong.” – March 19, 2008

Richard Lee is a Currency Strategist at FXCM.