The Fed meets Tuesday, as rising interest rates continue to defy the central bank's efforts to push them lower.
Economists, however, say there's little chance the Fed will waiver much from its November statement or its commitment to carry out its $600 billion purchase of Treasury securities, announced after its November meeting.
The Fed's controversial quantitative easing program, in theory, was supposed to drive rates lower and help reflate asset prices. Yet since it began the program, the yield on the 10-year Treasury has gone from about 2.6 percent in early November to a high of 3.39 percent Monday. It finished Monday trading closer to 3.293 percent.
"Don't they have to address the 100-basis point gorilla in the room?" said William O'Donnell, who heads Treasury strategy at RBS.
"What I'm most interested in is what they say about the structure of rates," he said. The Fed could note the higher rates reflect better growth, since economic data has improved since its last meeting, or it could say it's concerned rates are rising too much given the slow growth of the economy, he said.
The improvement in the economy has also led to speculation about whether the Fed could hold off on some of its easing, O'Donnell, however, expects the Fed to carry out its full program. "I think they would look at all of this and say a few months don't make a trend," he said.
Ian Lyngen of CRT Capital said it's possible the Fed could give a nod to the economic improvement, in part because of the fiscal stimulus in the tax package being voted on in Congress this week.
"That might influence their spin on the mixed data we are seeing," he said. Lyngen said since beginning the QE program Nov. 12, the Fed has purchased $114 billion in Treasurys, $75 billion of which were related to the new QE program. The balance were Fed purchases related to the reinvestment of the proceeds of maturing mortgage securities.
J.P. Morgan economist Michael Feroli says not much has shifted in the economy to warrant the Fed to do much tweaking to its statement. But he illustrated an interesting point about the Fed, its easing program and the economy in a chart he released Monday. (See the chart below.)
Feroli tracked the amount of Google searches for the term "double dip," highlighting how internet searches about a double dip recession peaked in late August when Fed Chairman Ben Bernanke first suggested the Fed may do more easing. Since that time, the amount of searches have fallen sharply, and so have market expectations for a double dip.
Fighting the Fed
Markets immediately began to respond to the Fed's easing plans when it was just a suggestion in August. Since then, the stock market has made sharp gains, with key indices at more than two-year highs. Treasury yields initially declined as buyers ran into the bond market, and yields bottomed in October, with the 10-year at just above 2.3 percent.
But since the Fed announced the program, the bond market has been fighting the Fed.
"The Fed by indicating in November that rates would be kept low for an extended period, it basically tried to prod investors to move out the risk spectrum, a rebalancing effect...Risk taking comes at the expense of Treasurys," said Tony Crescenzi, market strategist with Pimco.
Crescenzi said rates, in fact, could have been higher were it not for the Fed purchases. "Oddly, the Fed's actions have hurt Treasurys even as the Fed is purchasing them. The true message of the asset purchase program is to make investors believe that rates will be kept low for an ... extended period. Number one is the signaling effect, and number two, it helps suppress any real rise associated with the improving economy," he said.
Mesirow Financial Chief Economist Diane Swonk says the Fed is unlikely to make any major changes when its statement is released. "But I wouldn't be shocked if something happened, because this is the opportunity to underscore things in a big way," she said.
She said one thing the Fed could do is say it would examine different maturities in the Treasury yield curve to achieve its goals.
Swonk notes that three outspoken Fed dissenters will become voting members of the Federal Open Market Committee in January. "There will be a dissent, but it's interesting to hear the dissenters from within the Fed have been much less verbal now that it's been politicized," she said.
Swonk was referring to the highly unusual level of international and domestic criticism lodged at the Fed over its QE program. As the Fed's very suggestion of QE moved markets, the dollar took a dive, but it has since reversed some losses as the European sovereign crisis took center stage in November.
The dollar's decline sparked an outcry in the international community about the Fed's "manipulation" of the currency. Domestic critics, meanwhile, complain the Fed has too much power. It is also expanding its balance sheet at a time when fiscal constraint is a hot political topic. The euro gained more than 1.2 percent against the dollar Monday, ahead of the Fed meeting. The euro also moved with risk assets, which rose Monday after strong Chinese economic data and the Chinese withheld an expected rate rise.
Besides the Fed meeting Tuesday, investors are watching retail sales at 8:30 a.m. for November, and the NFIB small business survey at 7:30 a.m. Producer price inflation data is also released at 8:30 a.m.
Best Buy also reports earnings Tuesday.
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