Quantitative Wheezing

Friday's Non-Farm Payrolls report continues to roil the financial markets. Expectations had coalesced around a 125,000 net gain, but were dashed when only 96,000 positions were added and the previous two months’ gains were revised down by 41,000 in total.

At the Federal Open Market Committee's last meeting in early August, most members agreed that more stimulus would be required if a "substantial and sustainable strengthening" in the economy did not become evident.

Few would argue that this has transpired, making it likely (but not certain) that the central bank is poised to do something in an effort to stimulate activity.

So, traders are breaking champagne bottles over the bow of the QE3, betting that the Fed will launch it down the slipway after its meeting on Thursday.

The question now is what the vessel itself looks like.

Our educated guess is that Captain Bernanke and his mates will opt for an open-ended series of bond purchases. This would entail acquiring Treasury and mortgage-backed securities at an adjustable pace until the Committee determines that the economy has recovered to its satisfaction.

This has a number of strategic benefits.

By keeping the total size of the eventual programme undetermined, the bank will ward off traders who are inclined to bet against it. In giving officials the ability to wind purchases down, it allows them to react quickly in the event of a rise in inflation. And by essentially guaranteeing that purchases will continue until conditions improve, the bank will help to provide a sense of security to lenders and business owners who are considering investment plans in such an uncertain environment.
This analyst suspects that this will have a relatively muted impact in the real world, where the traditional transmission mechanism between interest rates and borrowing activity has seriously deteriorated in the last five years.

But the markets will unquestionably feel the effects. At the time of writing, the dollar is down, and commodity prices are up sharply, as investors forecast a dilution in the currency's value.
How durable will this be?

Perhaps for longer than we've become accustomed to. While a short-term trend reversal is likely to occur immediately following the announcement (sell on rumour, buy on news), we may see a more sustained period of dollar weakness driven by the open-ended nature of the Fed's commitment. By making the stimulus gradual and long-term, the bank may help to alleviate the "sugar rush" effect that has accompanied the last two rounds.

However, that will come to a screeching halt in the event that conditions elsewhere deteriorate. Low interest rates in the United States are wonderful while there are attractive opportunities elsewhere: traders can borrow in dollars and earn handsome rewards. But if China continues to slow and shred growth in the emerging economies, money will come home in a hurry.

And in a side note: If you thought the wailin' Germans were loud, wait until you hear the howling Republicans on Friday--buy some earplugs, and have a great week!