It’s common for equities to sink in the hours before the FOMC releases its policy statement  as investors trade cautiously in case the central bank adopts a new tone. After yesterday's sell off, cautious traders are returning stocks to the middle of their recent range as many market participants expect Chairman Ben Bernanke to keep his promise and hold interest rates close to zero for an extended period.

"We expect it there for pretty much all of 2010," said David Ader and Ian Lyngen, strategists at CRT Capital Group, commenting on the Fed Funds rate.

Three hours into Wednesday’s session, the NASDAQ is leading the way with a 1.65% advance to 2,002, followed by a 1.31% climb in the Dow to 9,362, and a 1.25% hike in the S&P 500 to 1,006. All three indexes are rebounding from two days of losses.

In the fixed income world, yields on the 10-year note have risen six basis points to 3.70%, just thirty minutes before the government issues a record $23 billion in 10-year notes. In total this week, the government is auctioning $75 billion in new debt.

In addition to preparing for the FOMC statement, markets have been reacting to June’s smaller than expected trade deficit, which was posted an hour before the opening bell.

A jump in oil prices allowed imports to advance faster than exports in June, causing the US trade deficit to expand compared to May, yet overall the debt was just $27.0 billion in June, compared to the median forecast of $28.5 billion.

Imports advanced by $3.5 billion in the month to come in at $152.8 billion, largely on account of petroleum imports rising 24%. The gain was due to prices more than volume, as crude oil jumped from $51.21 per barrel in May to $59.17 in June, the highest level since November.

Exports were boosted by a weak US dollar, but the $2.4 billion advance to $125.8 billion failed to keep pace with the rise in imports. 

When oil is excluded from the equation, the volume of imports actually fell to its lowest level in nearly six years. Moreover, when inflation is taken into account, the trade deficit  actually sank to $35.9 billion, the lowest level since December 1999.

“On the surface, the report is somewhat discouraging solely on the fact that the headline number implies a worsening U.S. trade deficit,” said TD strategist Ian Pollick. “However, when looking at the details of the report it becomes apparent that from an ex-petroleum perspective in addition to looking at the data in real terms, that the U.S. trade balance actually fared much better in June.”

Other analysts pointed out that the deficit should help the economy return to growth in the current quarter, following a record of four consecutive retractions.

“With the dollar on the defensive and external demand likely to rival domestic spending, the trade deficit should continue to narrow, supporting a mild U.S. economic recovery in H2,” commented Sal Guatieri from BMO Capital Markets.

One final reminder: the Treasury’s Budget Statement for July is released at 2pm, just before the Fed’s policy statement. 

The budget statement rarely causes mass movement in the markets, but the deficit is expected to be $190 billion, which would mean the government created a $1.3 trillion hole in the first 10 months of the fiscal year. To some extent that’s old news, but anyone adopting the buy-and-hold strategy can’t be encouraged by media reports that quote pundits warning the government could eventually implode.