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Tuesday Look Ahead: Fed Next Move A Hot Topic for Markets

Tuesday, 10 Aug 2010 | 12:02 AM ET

Tuesday's FOMC meeting is the most anticipated Fed meeting of the year.

The Fed holds its regular, one-day meeting Tuesday and is expected, as always, to release a statement at around 2:15 p.m. But what it will say in that statement is at the heart of a debate among Wall Street's deeply divided economists over what steps, if any, the Fed will take.

One view is that the Fed will embark on a new quantitative easing program, by reinvesting the proceeds of its maturing mortgage securities in Treasurys, or even more mortgages. Another group does not think the Fed would make such a move unless the economy significantly worsens later on. Yet, they all agree the Fed could give a nod to a weakening economy.

"That's the only story tomorrow," said Knight Equities managing director Peter Kenny of the Fed meeting.

"Earnings season is winding down, and now the focus is going to revert back to the economy and frankly that's not particularly good," said Kenny. There are a few pieces of economic news ahead of the Fed meeting, including the NFIB small business survey at 7:30 a.m.; productivity and costs, at 8:30 a.m., and wholesale trade at 10 a.m.

The Treasury auctions $34 billion in 3-year notes at 1 p.m., and there are just a few earnings. Disney reports after the closing bell.

Stocks traded quietly Monday, ahead of the Fed meeting, and Treasury prices mostly edged lower. The Dow was up 45 at 10,698 and the S&P 500 was up 6 at 1127. The dollar, counter to recent trends, was also higher against major currencies, while stocks rose, and some commodities, like oil, gained.

"We've seen this head fake before," said Kenny. "If we don't see quantitative easing, I think we're going to see the (stock) market drift a little bit lower, but I don't think we're going to see anything terribly dramatic. If we get it, it will support the trend."

Kenny said the low-volume trading of August could be good for stock prices, which may float higher with little effort. "I think in September you're going to see a reintroduction of elevated volatility. That's going to be in vogue in September, and portfolio managers are going to start gearing up for the year end," he said.

QE or No QE?

Goldman Sachs economists Friday said they believe the Fed will announce the first step toward a new round of quantitative easing, which would be reinvesting maturing mortgages in Treasurys. They added that it could be the first part of a program under which the Fed could buy ultimately $1 trillion of Treasurys. The idea is that the Fed would keep capital in the banking system as a result.

But many other economists disagree. "I don't think they're going to to do anything. They'll tweak things a little bit. I think they'll acknowledge the economy is a little bit softer, but at the same time financial conditions improved so I think that will give them confidence things will get better over time," said Joseph LaVorgna, chief U.S. economist at Deutsche Bank.

"The market is looking for the Fed to do something symbolic. I'm not sure what it gets them. Interest rates are not the problem. Mortgage rates are at record lows. Corporate rates are at record lows. Most corporations can access the capital markets relatively easily. It seems to me the price of credit is not a problem," LaVorgna said.

The debate about quantitative easing was sparked late last month by comments from St. Louis Fed President James Bullard, who suggested the Fed may have to buy more Treasurys as he warned about Japan-style deflation. The idea gained momentum, but expectations for a quantitative easing move at this Fed meeting really took off after Friday's surprisingly weak July employment report.

"Bottom line, the Fed's decision about quantitative easing. Does it really depend on one jobs report? Probably not. Where's the bar for quantitative easing? I think the bar's kind of high," said Marc Chandler, chief currency strategist at Brown Brothers Harriman.

Chandler expects the Fed to hold off on quantitative easing at this meeting. If that's the case, the dollar would benefit. "I think the Treasurys would sell off a little bit. Treasurys selling off a little bit is good for the dollar," he said.

"After Friday's jobs data, there's been no follow through dollar selling. Both the dollar and stock market are up today," he said on Monday afternoon. "This is the kind of thing that people like me, who are still a little optimistic, want to see. We want to see the market shrug off some bad news and we want to see the dollar rally along side the stock market."

Ian Lyngen, senior Treasury strategist at CRT Capital, said the anticipation ahead of the Fed meeting may constrain some bidders for the government's 3-year notes auction. "Of all the refunding, this is typically the easiest leg to take down," he said of the 3-year. "My concern is the market is going to be fairly limited in their risk taking appetite so close to the Fed so that might sideline some potential market participants."

Lyngen said the market has gotten ahead of itself, pricing in anticipated quantitative easing. "While clearly the Fed has an opportunity to create more accommodative monetary policy by reinvesting the maturing MBS holdings into the Treasury market or other securities, the sense we get is that type of decision is still a ways away," he said.

If the bond market's expectations are not met, Lyngen said investors will turn their focus to the minutes of the FOMC meeting, in an effort to handicap the Fed's next move. The minutes are released at the end of the month and will show what type of discussion the Fed had about quantitative easing.

"From a market perspective, we probably trade back to the mid- to low- 2.90s (10 year yield), maybe mid 2.90s with a chance at 3 percent over the coming three days as we accommodate 10 - and 30-year auctions. The market will probably correct to higher rates, but still in the new lower range," he said.

Hurd on the Street

Hewlett-Packard's CEO shocker dragged down the company's stock Monday, and erased more than $8 billion in market cap on the first trading day after the company reported Mark Hurd was out. Hurd's exit comes after he personally settled a sexual harassment case, filed by former actress Jodie Fisher, a marketing consultant for HP. Hurd apparently was cleared of any sexual harassment violations by the company but was found to have violated HP business standards.

Corporate Bond Gusher

Another $7 billion of new corporate debt came to market Monday, after last week's $31.8 billion in investment grade bonds, the highest weekly issuance since May, 2008.

Issuers included Anadarko, Toyota, WellPoint, Orange and Rockland Utilities and Developers Diversified.

- Follow me on Twitter @pattidomm.

Questions? Comments? Email us at marketinsider@cnbc.com

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