The Federal Reserve has done a complete 180 over the past two weeks, as the central bank has dropped their long held stance that inflation remains their “predominant concern” and instead, has finally turned their focus to the rapidly deteriorating status of the economy and financial markets. Now that they have injected billions of dollars of liquidity into the banking system and have even slashed the discount rate by 50 basis points, fixed income markets are betting on multiple cuts to the overnight lending rate this year. The question now remains: how many basis points lower will the Fed take rates in September and more importantly, will it save the markets from a liquidity crunch?

Yield Spread Analysis 08/14 – 08/21

Price action in government bond markets proved to be hectic once again over the past week, as fears of a massive liquidity crunch 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 21.5 basis points in the US, 6 basis points in the UK, and a whopping 45 basis points in Canada. Meanwhile, short term yields in New Zealand actually rocketed 18 basis points higher, as investment has been flowing towards longer-term contracts and kiwi uridashis. Furthermore, yields are much lower on the long-end as well, leading most yield curves to flatten and boding ill for growth outlooks. For example, though the spread between short-term and long-term yields in the US widened, the decline in rates below 5.00 percent signal expectations for rate cuts by the Federal Reserve as economic expansion remains tepid.

Looking ahead, thin economic data provides little event risk for fixed income markets, especially as the Bank of Japan is highly unlikely to take any sort of policy action. However, traders should be keenly aware of risk aversion trends, as this has been the main driver of price action in equities, bond, and forex markets.

US Fed: September Rate Cut In the Cards – Will It Be 25bps or 50bps?

The Federal Reserve has done a complete 180 over the past two weeks, as the central bank has dropped their long held stance that inflation remains their “predominant concern” and instead, has finally turned their focus to the rapidly deteriorating status of the economy and financial markets. Now that they have injected billions of dollars of liquidity into the banking system and have even slashed the discount rate by 50 basis points, fixed income markets are betting on multiple cuts to the overnight lending rate this year. The question now remains: how many basis points lower will the Fed take rates in September and more importantly, will it save the markets from a liquidity crunch?

The Federal Open Market Committee's Statement

“Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.” – August 17, 2007

Donald Kohn, Federal Reserve Vice Chairman (Voting Member)

“The reaction of financial markets (to recent developments in the subprime sector) raises the possibility that credit availability could be hampered for a larger group of households, which could, in turn, have effects on the broader economy…To be sure, the moderation in economic growth and, in some cases, higher interest rates have probably made it more difficult for some borrowers to service their loans … however, a key determinant appears to have been the sheer amount of debt relative to the value of the house taken on by some borrowers.” – August 20, 2007

Mr. Poole could be eating his words next month:

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

“It's premature to say that this upset in the market is changing the course of the economy in any fundamental way. Obviously, there could be an impact, but we have to rely on some real evidence…The issue for me is whether it's going to spread into business fixed investment and the consumer segment more broadly. I don't see evidence that that's taking place…barring a calamity there is no need for a rate cut.” – August 16, 2007

BOJ: Will A Determined Fukui Dare To Raise Rates This Year?

While markets are currently expecting most central banks to cut rates or hold off on previously expected rate hikes this year, Bank of Japan Governor Toshihiko Fukui is widely perceived as remaining determined to secure his legacy of “normalizing” monetary policy after putting an end to ZIRP in 2006, despite major resistance from political officials and the fact the economy still teeters on the edge of deflation. While we do not expect any policy action from the central bank this week, traders will be waiting for commentary signaling a hike later in the year:

Koji Omi, Japanese Finance Minister

“I want the BOJ to continue to support the economy with its policy, although individual policy decisions, as I always say, are up to the bank…Thanks to speedy action by central banks around the world, including the BOJ, the worst period (of market turbulence) seems to be over. Nonetheless, we need to closely monitor its developments and impact on the Japanese economy.” – August 15, 2007

Hiroko Ota, Japanese Economics Minister

“I think the BOJ will make a decision at next week's policy-setting meeting after closely analyzing Japan's economy and prices and market conditions…It's not clear how widely the subprime problems may spread (worldwide), so we're closely watching them.” – August 15, 2007

Heizo Takenaka, Former Economics Minister

“If you ask me if the BOJ should hike (in August), I would say no. If you ask me if there is a possibility for a rate rise this month, the answer is yes…What we need to be careful of is that the European, Chinese and Japanese economies have all become very reliant on US growth…the impact could be significant.” – August 17, 2007

Terri Belkas is a Currency Strategist at FXCM.