Fed Weighs Expectations of Higher Growth with Rising Treasury Yields

The Fed comes into its latest FOMC meeting today with the US economy showing some stronger data, while at the same time yields have climbed higher since the announcement of a tax deal between the Obama administration and Republicans. The plan would extend tax cuts, cut the payroll tax, and extend unemployment benefits. The deal is expected to drive growth through 2011 in the US, and that has caused a sell-off in Treasurys.

There are two points to the story however, as higher expectations for growth are coupled with extra stimulus measures that likely weaken fiscal position of the United States. That was the warning from Moody’s yesterday. The US tax-break plan could endanger the US top-level credit grade since it would only add to the bloated government deficit and ballooning national debt. Long term doll bears are probably licking their lips in anticipation of any potential negative impact on the dollar from the unsustainably elevated US fiscal position.

We counter those long term concerns about US fiscal health with the recent run of positive data includes stronger ISM Manufacturing Index to start the month, jobless claims that have dipped to levels not seen since 2008, a big jump in US exports in last Friday’s trade data, and today’s better than expected retail sales report.

With this data from the past 3 weeks in hand, would the Fed have gone through with a $600 billion bond purchase program (QE2)? It’s an important question and the answer is likely yes, because inflation continues to be muted and the unemployment rate remains stubbornly high.

Therefore, what will the FOMC focus on in today’s statement? The Fed could sound more dovish as Fed policy makers see yields climbing higher – which means QE2 is not having the desired affect of keeping yields down. Or they can raise the outlook for the economy and send signals that they feel less pressure to support the economy. That would be a USD positive development.

Which message the Fed focuses on will decide how currency markets react to the decision.
www.fxtimes.com