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Fed's Bernanke Issues Inflation Warning, but Traders Expect a 92 Percent Chance of a Rate Cut in December

Thursday, 08 November 2007 18:19:03 GMT  |  David Rodriguez, Currency Analyst

The US dollar continued to falter against major forex counterparts, as traders kept the downtrodden currency near record-lows against world currencies. In fact, the British Pound forged fresh 26-year highs against its cross-Atlantic rival, while the Euro fell just short of record-peaks through time of writing. Central bank interest rate decisions and speeches forced pronounced intraday volatility across major currency pairs, and the net result was to leave the dollar lower through the New York afternoon.

Early-morning interest rate announcements by the European Central Bank and the Bank of England highlighted event risk on the trading day, with unchanged rates from both monetary policy authorities leaving their respective currencies higher against the downtrodden US dollar. A later speech by Federal Reserve Chairman Ben Bernanke capped the morning of central bank activity. The head central banker offered a relatively pessimistic outlook for domestic growth and inflation prospects, saying that US GDP expansion would slow considerably in the final quarter of the year. Bernanke likewise forecasted that inflation will remain elevated through the same period, leaving the Fed with the difficult prospect of rising price pressures and slowing economic activity.

Despite the fairly direct warning on price pressures, markets subsequently increased expectations for Fed interest rate cuts through the medium term. The Fed Funds Futures contract for December lost 4 basis points in yield, leaving an implied 92 percent chance of a rate cut in the FOMC’s December meeting. Such expectations represent a fairly substantial shift in sentiment, as traders had previously priced in a 70 percent chance of the same outcome through yesterday’s trade. The dollar unsurprisingly moved lower on such prospects, but it is interesting to note that it did not establish record-lows on a trade-weighted basis. Indeed, the greenback remains above yesterday’s all-time trough, and price action suggests that traders are increasingly unwilling to press the dollar to fresh depths.  

US stock markets posted a particularly bearish reaction to Fed Chairman Ben Bernanke’s pessimistic outlook on growth, with the Dow Jones Industrial Average showing a substantial 167 point decline to 13,133. Yet the biggest percentage loser was by far the tech-heavy NASDAQ Composite, which shed a whopping 78 points to monthly lows of 2,671. Investors grew especially pessimistic for the future of technology share performance, as market titan Cisco Systems warned of slowing demand from financial and automobile companies. The highly diversified S&P 500 index likewise fell sharply, losing 1.2 percent to 1,458.

Short-term US Treasury yields fell sharply on shifting interest rate expectations, with the 2-Year Note losing 8bp to 3.46 percent. The longer-dated 10-year Note likewise slipped 4bp to 4.27 percent—underlining renewed risk aversion across financial asset classes. 

Written by David Rodríguez, Currency Analyst for DailyFX.com

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