While you wouldn’t know it by looking at the US Dollar, bond markets have shifted towards pricing in a 100% chance of a 25 basis point rate cut by the Federal Reserve in January. The combination of easing inflation along with mounting credit risks to the financial markets have proven to quell the hawkish leanings we’ve seen from the central bank in previous months. If these issues persist, it may only be a matter of time before we see a move down to 5.00%.

This week in Central Bank Speak:

US Fed – Slowly Working Towards A More Dovish Stance
PBOC – Will China Respond To A Protectionist Push By The US?
BOJ – Deflation and DPJ Limit Rate Hike Possibilities

Yield Spread Analysis 07/24 – 08/01

Global government bond yields have plummeted over the past week, especially on the long-term end, as risk aversion permeated through the markets and sent prices soaring higher. Credit concerns continue to loom, especially after Bear Stearns prevented investors from taking their money from a hedge fund that put some $900 million in mortgage investments. However, unlike Bear Stearn’s other two troubled funds, the group borrowed no capital and had almost no exposure to subprime mortgages. Reaction most evident in US rates, which have fallen quite a bit and have received little help from economic data, which has only led the markets to price in a 100 percent chance of a 25 basis point rate cut in January. Elsewhere, Australian short term rates jumped after retail sales surged and CPI proved to be hotter-than-expected.

Looking ahead, the ECB and BOE rate decisions on Thursday are not likely to be major market movers, as both central banks are anticipated to leave rates steady. Furthermore, without a rate hike, traders will have little to go on as a policy statement will not be released by the BOE. Meanwhile, the ECB meeting will be conducted via teleconference and central bank President Jean-Claude Trichet will not give his usual press conference.

US Fed – Slowly Working Towards A More Dovish Stance

While you wouldn’t know it by looking at the US Dollar, bond markets have shifted towards pricing in a 100% chance of a 25 basis point rate cut by the Federal Reserve in January. The combination of easing inflation along with mounting credit risks to the financial markets have proven to quell the hawkish leanings we’ve seen from the central bank in previous months:

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

“Oil price increases over the past several years are, in percentage terms, roughly comparable to the 1970’s episodes but overall inflation has remained relatively contained, and unemployment has even fallen.” – July 25, 2007

“Economic data and anecdotal information show inflation moderating a bit…All of that is hopeful, but not yet decisive…There is certainly no reason, in terms of employment or output growth, as far as we can see, that…we have to quickly respond to signs of moderation in inflation.” – July 25, 2007

“The Fed doesn't know, and market participants do not know either, the full implications of last week's stock market declines and increases in risk spreads…The market understands, I believe, that the Fed will act in due time if and when evidence accumulates that action would be appropriate…The Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment, or when financial-market developments threaten market processes themselves.” – August 1, 2007

Timothy Geithner, New York Federal Reserve Bank President (Voting Member)

“Overall, the US economy continues to display remarkable resilience and flexibility, despite a range of adverse shocks…The size of the US fiscal deficit is unsustainable and that policy needs to bring it more into balance…the size of the gaps between spending and expenditure have been masked in recent years by a substantial, unanticipated and probably transitory surge in revenues, and by an unusually long period of unusually low long-term interest rates, in part the consequence of foreign official capital flows.” – July 26, 2007

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

“If I started to see some of the spillovers occur in some of the prime mortgages, I'd get more nervous. Things like serious, substantial falls in consumer spending or employment begin to tail off. And we don't see that much. From the Fed's point of view, the real issue is not to stop or contain adjustments in markets. Our prime concern needs to be whether there are system effects of what's going on.” – July 25, 2007

PBOC – Will China Respond To A Protectionist Push By The US?

The US Senate has approved two currency bills requiring the Commerce Department to take “currency undervaluation” into account when calculating anti-dumping duties on foreign goods. The bill would also implement a new semi-annual report identifying countries with “fundamentally misaligned” currencies and would require the administration to take action through the International Monetary Fund and the World Trade Organization against targeted countries that refuse to reform their currency policies. This has not gone over well with those involved in ongoing attempts to solve US-China trade disputes diplomatically:

Charles Schumer, US Senator and Finance Committee Member

“It is time to pass legislation that will have a real effect, and this bill will. A vote of 20-to-1 signals veto-proof support and shows the Chinese it is time to start playing by the rules." – July 27, 2007

Henry Paulson, US Treasury Secretary

“I understand the motivation behind the various currency related bills before congress and why Americans were frustrated by the imbalance in trade with China…However, I don't want China to become an increasingly big political issue in the US.” – July 31, 2007

Statement by the China Daily

“US lawmakers risk undermining efforts to strengthen ties and reduce the trade imbalance between the two countries…Unfortunately, the new US bill tends to mislead its people into believing that protectionism can be an answer to its economic woes.” – July 31, 2007

Statement by the US Treasury Department

“We particularly respect the efforts and intent of the Senate Finance Committee, however, (we) do not believe the approaches taken in the bill reported today would strengthen the hand of the United States in achieving essential economic reform. It distances the US from a multilateral approach and raises serious concerns regarding US compliance with international rules governing anti-dumping investigations…(The Treasury Department) continues to believe that direct, robust discussions with the senior Chinese leaders, not legislation is the best means of achieving progress." – July 27, 2007

Rodrigo Rato, International Monetary Fund Managing Director

“Greater exchange rate flexibility is not only in China's best interest, but would allow other Asian countries to appreciate with less concern about competitiveness. On the other hand, an intensification of trade restrictions on China would also have adverse affects on many other countries, including on other Asian countries that are tightly linked to China through global production chains.” – July 30, 2007


BOJ – Deflation and DPJ Limit Rate Hike Possibilities

Japanese central bankers maintain that there is the potential for rate normalization in August, while government officials still see the need for steady rates. However, now that the LDP has lost the majority to the DPJ in the Upper House elections, less active fiscal reforms could derail the economic growth that Japan has recently experienced, hurting prospects for monetary policy tightening in the future:

Tadao Noda, Bank of Japan Board Member

“We decide on monetary policy based on available economic data at each monetary policy meeting, and I will not rule out any policy options in August…we will determine policy by examining the overall economy, and not only specific data such as gross domestic product or the consumer price index.” – July 26, 2007


Hiroko Ota, Japanese Economics Minister

“The losses in the Upper House election have made it even more difficult to build a firm base of growth…We can't survive an era of falling birth-rates and aging population and globalization...without boosting economic growth and fiscal rebuilding…The end of deflation is in sight, but (the economy) has yet to escape from it completely.” – July 31, 2007

Yasuhisa Shiozaki, Japanese Chief Cabinet Secretary

“The real economy is expanding firmly. The same can be said of economies in major countries… the Bank of Japan is responsible for making monetary policy decisions, with government economic policy in mind.” – July 27, 2007

Terri Belkas is a Currency Strategist at FXCM.