It was only a week ago that the FOMC statement signaled that the Federal Reserve remained hawkish, but the recent liquidity crunch has forced the bank to add billions of dollars into the money markets. This “helicopter” drop of money, referenced in a 2002 speech given by Fed Chairman Ben Bernanke, has sparked speculation that the bank’s next move will be to cut rates. With US inflation figures due out on Wednesday, a weaker reading of the data may give the central bank the green light to take interest rates down 25 basis points to 5.00 percent.

US Fed – Will Bernanke Bail Out the Markets With a Rate Cut In September? BOE – CPI Drops Below Target: Is A Hike To 6.00% Still In The Cards?
RBA – Hike To 6.50%? Check. Next Stop 6.75%.

Yield Spread Analysis 08/07 – 08/14

Price action in government bond markets proved to be hectic over the past week, as a massive liquidity crunch sparked by BNP Paribas’s freeze on withdrawals on three funds led multiple central banks to pump cash into the financial markets in order to soothe volatility. The end result? Short term yields plunged dramatically on net by 14 basis points in the US, 7 basis points in Switzerland, and a whopping 23 basis points in Canada. Meanwhile, short term yields in the UK dropped significantly as well, but this was mainly the result of economic data. In fact, the weaker-than-expected release of UK CPI at 1.9 percent – below the BOE’s 2 percent target – led short term yields down 7 basis points, as the bank’s previously hawkish stance may turn to a far more neutral one.

Looking ahead, the release of US CPI on Wednesday could prove to be the market mover of the week, as Treasuries continue to rally amidst risk aversion and price in a September rate cut. With the Federal Reserve maintaining that inflation remains their predominant concern, only a softer-than-expected CPI report will give the bank the green light to do as the markets are hoping and decrease rates by 25 basis points to 5.00 percent. On the other hand, signs that price pressures remain firm could force the Fed to leave monetary policy unchanged, as a rate cut would undermine the bank’s inflation-fighting credibility.

US Fed – Will Bernanke Bail Out the Markets With a Rate Cut In September?

It was only a week ago that the FOMC statement signaled that the Federal Reserve remained hawkish, but the recent liquidity crunch has forced the bank to add billions of dollars into the money markets. This “helicopter” drop of money, referenced in a 2002 speech given by Fed Chairman Ben Bernanke, has sparked speculation that the bank’s next move will be to cut rates. With US inflation figures due out on Wednesday, a weaker reading of the data may give the central bank the green light to take interest rates down 25 basis points to 5.00 percent:

The Federal Open Market Committee's Statement

“The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent...Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy…Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.” – August 8, 2007

Gary Stern, Federal Reserve Bank of Minneapolis President (Alternate Voting Member)

“Inflation has now been reasonably well contained for roughly two decades or so, and the consensus in favor of price stability has been sustained.” – August 8, 2007


BOE – CPI Drops Below Target: Is A Hike To 6.00% Still In The Cards?

BOE Governor Mervyn King has made it clear that he is a hawk at heart, as the BOE was one of the only global central banks to refrain from adding liquidity to the money markets. King has previously cited moral hazard as a reason to not bail out developing countries, and it appears that he holds the UK to the same standards. Nevertheless, with CPI now below the BOE’s 2 percent target, the bank may move to a more neutral stance, which could send the British pound plummeting further:

Mervyn King, Bank of England Governor

“The main upside risk to inflation is that, with a limited degree of spare capacity, businesses may be more confident about raising prices than assumed in the central projection.” – August 8, 2007

“Interest rates aren’t a policy instrument to protect unwise lenders from the consequences of their unwise decision.” – August 8, 2007

Andrew Sentence, Bank of England Monetary Policy Committee Member

“Financial-market developments will only impinge on inflation and the real economy insofar as they have substantial effects on businesses and households and the way they behave. I wouldn't want to draw any conclusions at the moment…As far as monetary policy is concerned, the benefit of our monthly cycle of meetings is that we get a chance every month to assess how all the factors, including financial markets, are affecting us…Global economic conditions can have quite an impact on the growth and inflation environment here. That doesn't mean we're impotent but we may have to lean in a different direction to keep the UK economy on an even keel.” – August 13, 2007


RBA – Hike To 6.50%? Check. Next Stop 6.75%.

After the Reserve Bank of Australia raised rates by 25 basis points to 6.50 percent, the central bank surprisingly maintained their hawkish stance, citing inflation risks from economic expansion. With the labor market and consumption growth remaining resilient, it appears that the RBA has left to door wide open for additional rate hikes:

Glenn Stevens, Reserve Bank of Australia Governor

“At this stage, the evidence continues to point to strong growth in the global economy overall…Ongoing pressures are currently forecast to keep both underlying and CPI inflation near the top of the target range during 2008…In assessing medium-term prospects it will remain important to keep a close watch on both domestic inflation risks and any further developments in international financial markets and their possible implications for the global economy.” – August 13, 2007

Peter Costello, Australian Treasurer

“We are pressing now towards full employment. Some of the resource states are doing well but there are other states doing even better in terms of job creation over the last 12 months. Whilst mining is an important industry for Australia, there's no doubt about that, these jobs are not all the consequence of the mining industry and they're not all in mining states. It's very broadly based indeed, and that's good news.” – August 9, 2007

“Underlying inflation will be within our band. And bear this in mind, our band is 2-3 percent over the course of the cycle and you have to say the cycle is at its high point now. To still be within the band at the high point of a cycle shows how much low inflation is entrenched…I'm not going to talk about future movements of monetary policy.” – August 13, 2007

John Howard, Australian Prime Minister

“I am aware, and the Government is aware, that this (RBA) decision will hurt some homebuyers, and we're very conscious of that. It will have an impact on some household budgets.” – August 8, 2007

“There is nothing in today's decision which suggests that the economy is weakening. Rather the very strength of the economy as identified by the governor as the principal reason why there are pressures necessitating this interest rate adjustment.” – August 8, 2007

Terri Belkas is a Currency Strategist at FXCM.