Following 125bps worth of rate cuts by the Federal Reserve within two weeks, US stock markets have recovered quite a bit. However, that doesn’t necessarily mean the Fed is in the clear. Indeed, US economic data continues to deteriorate, as January non-farm payrolls unexpectedly fell negative while consumer confidence has turned increasingly pessimistic and personal spending has softened. As a result, fed fund futures are pricing in a 74% chance of another 50bp cut next month, but there are signs in the FOMC policy statement from last week that the central bank may moderate their aggressive policy actions. The most glaring indication is the dissent by Dallas Fed President Richard Fisher, who is known to be quite hawkish. With price pressures remaining persistent, additional increases in US inflation reports could prevent other members from voting for another round of rate cuts as well, which could provide a huge boost for the US Dollar.
Yield Spread Analysis 01/29 – 02/05
Global fixed income markets were relatively quiet of the course of the past week, as equity markets recouped some of their losses and 125bps worth of rate cuts by the Federal Reserve helped alleviate the concerns of jittery financial markets. Of course, the policy actions by the US central bank led yields lower, and helped push rates on Canadian government bonds down as well. Meanwhile, an expected rate hike to an 11-year high of 7.00 percent by the Reserve Bank of Australia pushed short-term yields in the country quite a bit higher. While the RBA policy statement left the door open to additional rate increases, it also suggested that slowing global growth would take a toll on Australia as well and subsequently alleviate some of the existing inflation pressures.
Looking ahead, the European Central Bank and Bank of England rate decision provide substantial event risk. Despite ECB President Trichet’s hawkish rhetoric, the bank is not expected to raise interest rates. Meanwhile, a Bloomberg News poll of economists shows a chance that the BOE will cut rates by 25bp to 5.25 percent. However, given BOE Governor King’s inflation concerns, the UK central bank may opt to leave rates on hold, and the divergence between actual results and market expectations could lead the British Pound and UK Gilts on a bumpy ride.
US Fed: Is the Rate Cut Cycle Over Yet?
Following 125bps worth of rate cuts within two weeks, US stock markets have recovered quite a bit. However, that doesn’t necessarily mean the Federal Reserve is in the clear. Indeed, US economic data continues to deteriorate, as January non-farm payrolls unexpectedly fell negative while consumer confidence has turned increasingly pessimistic and personal spending has softened. As a result, fed fund futures are pricing in a 74% chance of another 50bp cut next month, but there are signs in the FOMC policy statement from last week that the central bank may moderate their aggressive policy actions. The most glaring indication is the dissent by Dallas Fed President Richard Fisher, who is known to be quite hawkish. With price pressures remaining persistent, additional increases in CPI and other inflation reports could prevent other members from voting for another round of rate cuts as well. Meanwhile, the FOMC added a sentence noting that their policy actions should help “promote moderate growth over time,” suggesting that they may have their economic concerns covered for now. Nevertheless, should economic data worsen or financial markets destabilize once again over the next few weeks, there is little doubt the FOMC will order additional reductions in the fed funds and discount rates.
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FOMC Policy Statement
“Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.
The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.
Today’s policy action, combined with those taken earlier, 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 continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.”
“Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting." – January 30, 2008
ECB: Will the Inflation Fighters Dare to Hike?
European Central Bank President Jean-Claude Trichet’s hawkish rhetoric has been hard to ignore over the past few months. While he has remained quiet over the past week, ECB Governing Council member Liebscher made a point of reminding the markets that the bank’s focus is still trained on inflation. However, European officials have started to voice their concerns that a US recession will take a toll on expansion in their own economy, which should be enough to prevent an actual rate hike by the ECB. Nevertheless, the ECB’s primary mandate is price stability and until CPI falls back from current levels of 3.1 percent towards the bank’s 2 percent ceiling, Trichet is not likely to even consider cutting interest rates.
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Klaus Liebscher, European Central Bank Governing Council Member
“Our entire efforts must be directed at reducing the increases in prices. Compensating inflation via higher wages or one-off payments from public coffers, go hand in hand with spiraling prices, rising budget deficits, higher taxes and finally end in lower competitiveness.” – February 4, 2008
Athanasios Orphanides, European Central Bank Governing Council Member
“As you know there has been a slowdown of the economy internationally. In the US there are some quite serious problems. For this reason we expect some slowdown for all of the Euro-zone compared to what we expected before. I want to say that the projections for the Euro-zone were very good, and some slowdown from very good projections is not something which should essentially worry us.” – January 29, 2008
Joaquin Almunia, EU Economic and Monetary Affairs Commissioner
“Up until now, our central scenario is of deceleration of growth, below-potential growth, but not of recession. The situation is delicate; of pronounced deceleration and below-consensus fourth-quarter growth...we will all be affected by what happens in the US economy, which is still the largest in the world.” – February 1, 2008
Pedro Solbes, Spanish Finance Minister
“I'm one of those that believe that if things go badly in the US, that's not good for Europe.” – January 31, 2008