What is the FOMC Going to Say ?

The FOMC holds a two day meeting starting tomorrow. No one is expecting a change in the Fed funds target of 0-25 bp. Nor is there much expectation that the FOMC announces an extension of its Treasury purchases--though no one expected the BOE to increase its purchases by GBP50 bln, announced last week, either. If the Fed were to announce an increase in its Treasury purchase program, which is to be completed next month, it would be a surprise and while it might lead to a quick uptick in the bonds, it would likely undermine the dollar.

The focus will be on what the Fed says and what the Fed says could be particularly important given that the OIS-Libor spread and Fed funds futures strip is pricing in a Fed hike for Q1 next year. Looking at the Fed funds futures, the Feb 2010 contract is implying an average effective Fed funds rate of 46.5 bp. There is no meeting in Feb, so this offers a relatively clean view of the Jan meeting. The March contracts is currently implying an average effective Fed funds rate of 59 bp. The meeting in March is near the middle of the month (March 16).

Anticipating that the Fed could tap down such expectations could lead to some profit-taking/short-covering ahead of the outcome of the meeting on Wed. In the statement following the June meeting, the FOMC said that it "...continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

It should not come as a shock if the Fed repeats this or something along similar lines. In recent weeks, several Fed officials, including Bernanke in Congressional testimony at the end of July, continue to express concern about the commercial real estate market. Reports indicates that some $165 bln of commercial mortgages need to be refinanced this year.

Although the June consumer credit report came out too late on Friday for most market participants to give it much attention, count on Fed officials to take note. Consumer credit, which was expected to have fallen $5 bln, it actually fell $10.3 bln and the May series was revised to show a $5.4 bln decline rather than the $3.2 bln decline initially reported. De-leveraging in the household sector continues and the officials will likely recognize this as a headwind on growth, even as they recognize not just that the pace of economic contraction is slowing, like they did in June, but may even upgrade its assessment.

While the 3-month TED spread is back to near normal levels (now quoted near 29 bp), and LIBOR is setting record low fixings, Fed officials seem to recognize financial markets are have not fully normalized.

Lastly, we note that in last week's report, the Federal Reserve indicated its assets stood below $ 2 trillion and is at the lowest level since Lehman failed, as some of the liquidity provisions, including, the swap lines with foreign central banks has fallen more than the amount of assets the Fed has purchased.