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US Dollar volatility is likely to continue ahead of an interest rate announcement from the Federal Reserve, with traders looking to key soundbites in the policy statement for cues on where the central bank will go from here.

Weekly Update

The Federal Reserve is widely expected to the keep its benchmark overnight interest rate steady between 0.00% and 0.25% on Wednesday. This weeks policy decision, like other recent decisions, is not expected to be market moving, but the statement following the meeting always bears watching. The FOMC has pledged repeatedly to keep the federal funds rate at œexceptionally low levels and œfor an extended period of time. Given the still volatile situation in Europe, it is extremely unlikely that the Fed would back off that pledge in this particular meeting. The Fed has also indicated that inflation œis likely to be subdued for some time, a view supported by government inflation figures; core consumer prices have only risen two months this year and are up 0.9% year-over-year, well below the 2% average increase over the past decade. Finally, the Fed has begun to sound a more optimistic tone with regard to the U.S. economy. From the April text, œthe labor market is beginning to improve. Growth in household spending has picked up While recent economic figures have been lumpy, they do still point toward a growing economy. It would be quite a surprise if the Fed was to temper its nascent optimism, but a note of caution with respect to the events in Europe is possible. Fed Funds futures suggest that the first rate hike will occur either in the March or April meeting in 2011, while overnight index swaps imply 42 basis points of hikes over the next twelve months.

Weekly Update

A few prominent ECB officials have been suggesting that the government bond buying program announced last month has been a success. While it is unknown what the benchmark for success is in this instance, it is unmistakable that yields in some of the more troubled Euro areas that have been targeted for this program are still relatively high. Yields on the Spanish 10-year surged to 4.88% last week, almost 100 basis points higher than levels immediately following the bailout announcement, though they have since fallen to near 4.46%, around the levels they were at before the May 10th announcement. In total, the ECB has made 51 billion euros worth of purchases under the government bond buying program. With regard to interest rates, market expectations are for 33 basis points of ECB hikes over the next twelve months.

Weekly Update

In a recent speech, BOE Governor Mervyn King remarked that removal of stimulus will be œthrough a rise in [the] Bank Rate with asset sales being conducted later in an orderly program over a period of time The governor said that upcoming budget cuts would influence the course of monetary policy, hinting that rates would stay low for at least the near-term. While the central bank is of the view that inflation will moderate going forward, UK CPI remains uncomfortably high; core consumer prices were up 2.9% year-over-year in May. Overnight index swaps imply that the BOE will hike rates 31 basis points over the next twelve months.

Weekly Update

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As expected, the Swiss National Bank held the target three-month Libor rate at 0.25%. The central bank sounded rather upbeat in the latest monetary assessment. œThe recovery of the global economy continues and the Swiss economy is benefiting from it, said the bank. 2010 GDP growth is forecast to be 2%, despite a strengthening of the Swiss currency versus the Euro, which is dampening export activity. The bank concluded that œdeflationary risk is Switzerland has largely disappeared. There was a word of caution, however, with reference to downside risks from the events in Europe: œshould these downside risks materialize and, via an appreciation of the Swiss franc, lead to a renewed threat of deflation, the SNB would take all measures necessary to ensure price stability. Notably, the June monetary policy assessment had no mention of currency intervention, which is in contrast to the March assessment. That combined with the overall upbeat outlook for Swiss economic prospects sent the Euro/Franc exchange rate to new all-time lows. Overnight index swaps suggest that the SNB will hike rates 34 basis points over the next year.

Weekly Update

BOC Governor Mark Carney remarked this week that the banks interest rate path is not œpreordained and that future policy would be œmore subtle. He said that recent Canadian economic developments were largely as expected, and that the country would lead G-7 growth over the next two years. Overnight index swaps are indicating that that the BOC will hike rates 25 basis points in the next policy meeting on July 20th and 129 basis points over the next twelve months.

As expected, the Bank of Japan held the target overnight interest rate at 0.1%, following the June 15th board meeting. Though optimistic about the economic recovery, the bank œrecognizes that Japans economy faces the critical challenge of overcoming deflation To this end, the BOJ introduced a long-term collateralized lending program set to begin by the end of August, 2010. The central bank will lend a maximum of 3 trillion yen under this program. Markets are expecting no rate hikes from the BOJ over the next twelve months.

The Reserve Bank of New Zealand hiked its official cash rate by 25 basis points on June 10th. The rate now stands at 2.75%. In a statement explaining the action, Governor Alan Bollard said that main impact on New Zealand from the recent financial market turmoil would œcome through continuing upward pressure on the cost of funds to the banking system. The RBNZ expects growth of around 3.5% in New Zealand this year and next and for inflation to track œwithin the target range, though the figure may increase temporarily due to government-related price changes. Further rate hikes will be reviewed œin light of economic and financial market developments. Overnight index swaps suggest that the RBNZ will hike rates at the next policy meeting on July 28th and 140 basis points over the next twelve months.

In the minutes to the June 1st meeting, the RBA noted that interest rates were at a level that was around the average of the past decade or so. The minutes indicated that because of the significant tightening that had already occurred, the central bank now had œthe flexibility to await information on how the recent market uncertainty might affect the global economy, as well as news about the outlook for inflation. Moreover, the RBA judged that it was appropriate to leave the cash rate unchanged œfor the near-term. Overnight index swaps suggest 35 basis points of hikes from the RBA over the next twelve months.

For a summary of past rate decisions, see our Central Bank Interest Rate Outlook

Written by: Sumit Roy, DailyFX Research
To receive future editions of this publication by e-mail, contact sroy@fxcm.com

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