NEW YORK (
TheStreet) -- With the
Federal Reserve's largely anticipated interest-rate decision just hours away, investors were bidding down the dollar and hoping the U.S. central bank would continue its pledge to keep rates "exceptionally low" for an "extended period" of time.
But given the economy's unexpected 3.5% expansion last quarter, and signs that deterioration continues to abate in the job and housing markets, the Fed may temper its language, even if it keeps its target rate down near 0%.
"The FOMC is unlikely to change its growth and inflation outlooks in next week's policy statement," says T. Rowe Price Chief Economist Alan Levenson, "but may consider softening its commitment to 'exceptionally low levels of the federal funds rate' in favor of 'accommodative policies' for an extended period."
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The Fed may also provide clues about how its plans to pull a tremendous amount of liquidity from the financial system once the recovery takes a stronger hold.
The Fed pumped more than $1 trillion worth of money into the markets through low interest rates, collateral-based lending programs and other means, and must extract those funds before inflation begins to roar. Some of those programs have already petered out or been scaled back as the private market has strengthened.
Last week, the Fed announced that over the next several weeks, it will halt its unusual tactic of buying $300 billion worth of Treasury bonds as well. Its program to buy $1.25 trillion worth of mortgage-backed securities is expected to continue through March.
"The best way for the Federal Reserve to smoothly exit from its current stance on monetary policy is to make it more a process than an event," says Anthony Crescenzi, a strategist at Allianz's behemoth bond shop, Pimco. "This approach has worked thus far."
Once those programs have ended, banks will still have too much money in reserve, and the Fed will still have a huge balance sheet saddled with over $2 trillion in Treasury bonds, MBS, debt issued by
Fannie Mae (FRE),
Freddie Mac (FRE),
Sallie Mae (SLM) and Ginnie Mae, as well as toxic debt from the government-supported rescues of
Bear Stearns and
American International Group (AIG). The Fed plans to resolve this imbalance in part through more transactions with banks called reverse repo agreements. In those, primary dealers lend money to the Fed in exchange for collateral, which is temporarily placed on their balance sheets.
The Fed recently tested this strategy in the market, and has indicated that a combination of reverse repos and gradually higher interest rates will put the economy back on an even keel without fueling higher prices.
Many economists believe the Fed will begin raising rates in mid- to late-2010, once it has begun the liquidity drain. In the meantime there will be opportunities for investors in the Forex, commodities and fixed income markets. Big banks like
Goldman Sachs (GS),
JPMorgan Chase (JPM),
Bank of America (BAC),
Wells Fargo (WFC),
Citigroup (C) and
Morgan Stanley (MS) have leveraged trading in those areas to boost capital-markets businesses or hedge their interest-rate sensitive mortgage-servicing portfolios.
Investors were sending the dollar lower and commodities higher on Wednesday morning, as gold reached a record spot price of $1,090.62 per troy ounce and oil topped $80 a barrel. The ICE Futures U.S. dollar index, which measures the dollar against six currencies fell 0.5%, with the euro buying $1.4781 and the British pound buying $1.6528. The Dow Jones Industrial Average was up 1.4% at 9,908.09 while Treasurys were losing ground, with the 10-year note yielding 3.49%, and the two-year note yielding 0.94%.
-- Written by Lauren Tara LaCapra in New York.
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