US Fed - Vigilant Policy to Keep Rates at 5.25%

Yield Spread Analysis 04/03 – 04/10
US, Canadian, and Japanese yield curves either inverted further or moved towards flattening as short term rates surged. In the US and Canada, the release of stronger-than-expected US Non-Farm Payrolls sparked much of the move, as tighter labor markets in the States bodes well for not only expansion there, but for their neighbor to the north as well. In Europe, the markets have moved back to their risk-seeking nature once again and selling bonds off left and right, subsequently sending yields - primarily on the long end – higher. However, the majority of the shifts were experienced Tuesday after four days off for the Easter holiday, as liquidity rushed back into the bond markets.

Looking forward, yields could continue to rise as the carry trade comes back in full force in the FX markets – a signal that traders are no longer risk averse. Furthermore, while the European Central Bank is anticipated to leave interest rates steady on Thursday, yields gain even more if ECB President Jean-Claude Trichet signals that monetary policy tightening is on tap in May with a return to the phrase “strong vigilance.”
Long Term** vs Short Term*

US Fed - Vigilant Policy to Keep Rates at 5.25%
Inflation data remains the name of the game for the Federal Reserve, as the central bank essentially brushes off the crunch of subprime lenders, even as it appears the probles have started spread to higher credit quality Alt-A laons:

Frederic Mishkin, Federal Reserve Board Governor (Voter)

“Inflation is higher than I would like to see” but it “is likely to moderate.” However, “if inflation doesn’t moderate, the Fed must act?. While restoring price stability remains critical, the central bank should do so at a pace that does not do undue harm to the economy.” – April 10, 2007

William Poole, St. Louis Federal Reserve President (Voter)

“Inflation is a major concern and if inflation were to head up in a convincing way from the current level, I could be in favor of a rate increase at some point?Chairman Greenspan often wrote with the expectation that people would read between the lines?Chairman Bernanke is trying very hard to have people read the lines and not draw implications from reading between the lines.” – April 3, 2007

Richard Fisher, Dallas Federal Reserve President (Alternate Voter)
“Thus far, the damage from the subprime market has been largely contained. … Quality problems have arisen primarily for adjustable-rate subprime loans, which are only about 8.5 percent of home mortgage debt outstanding? nevertheless, because 40 percent of homebuyers last year were non-prime?borrowers, housing markets may feel some short-term pains, making it less clear whether housing construction has bottomed and how long the housing downturn may last. Fortunately, the financial system and the economy are strong enough to weather this storm?There is no denying that this kind of situation dampens economic growth?I would like to see inflation lower than it currently is?I am hopeful inflation will moderate, but we must always remain vigilant.” – April 4, 2007

BoJ – Little Hope for Hikes
While the Bank of Japan and fiscal officials tout the optimistic prospects for the Japanese economy, it is clear that concerns about core prices and wage growth will keep the central bank from being able to even consider normalizing rates until much later in the year:

Toshihiko Fukui, Bank of Japan Governor

“Core prices may hover near zero in coming months” and “wage growth is very mild” but they may “rise in the long run” as the “labor mismatch will create price pressure?Japanese consumer still expect mild inflation?recent data show Japan’s consumption is solid “ while “Tankan shows business confidence is in good shape.” – April 10, 2007

Toshiro Muto, Bank of Japan Deputy Governor

“The policy board came to the conclusion that the Japanese economy is likely to continue a long-lasting expansion, supported by the virtuous cycle of production, income and spending… As for consumption, the softness since last summer has proved temporary and we confirmed it is on a rising trend. Looking at the economy and prices in the next couple of years, based on our forward-looking perspective, we judged that consumer prices were likely to be in a rising trend, even if they fall year-on-year in the near future. We’ve come across the view that the BOJ’s rate hike was targeted at currency levels and yen-carry trades, but that’s not the case.” – April 4, 2007
“We don’t have any time frame for future rate hikes. Our future policy adjustments will be based on economic and market moves”. He added that "Japanese economic growth this fiscal year is expected to be slightly above its potential economic growth rate.” – April 4, 2007

Hiroko Ota, Japanese Economics Minister

“Household consumption figures for January and February were good, although we need to wait a little longer to determine the trend.” – April 10, 2007

Koji Omi, Japanese Finance Minister

“The Japanese economy overall is recovering steadily. I’ll tell them (the G7) that we’re confident about the strength of the Japanese economy.” – April 9, 2007