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FOMC Preview: Yes or No to QE?

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management

The euro is trading sharply higher this morning, thanks to the German Constitutional Court's nod of approval to Europe's rescue fund.

Now that this week's major European event risk is behind us, the focus will shift to Thursday's Federal Reserve monetary policy announcement. Expectations for a third round of Quantitative Easing has contributed to broad based dollar weakness, adding to the rally in the EUR/USD. Since Friday's non-farm payrolls report, the EUR/USD has risen from a low of 1.2627 to a high of 1.2936 this morning. We know that this move is not entirely euro driven because USD/JPY also broke 78 this week, dropping to its lowest level in 3 months. Investors are positioning for QE3, and the majority of economists expect the central to ease. After last Friday's surprisingly weak non-farm payrolls report, even the skeptics were convinced that more stimulus is on its way.

It is no secret that the lack of jobs is the number one problem for the U.S. economy, and also the main reason why QE3 is needed. Back in August, Federal Reserve officials made a strong case for easing in September. When the July NFP numbers were released and job growth jumped by 163k, investors were skeptical about whether the central bank would proceed with QE3. However, after seeing job growth retrench in August and rise a mere 96K, the Fed was certain to act in September. The numbers in the following chart show how the momentum in the labor market has been waning. Less than 100k jobs were created four out of the last five months, which represents a significant slowdown from the 225k jobs that the economy was averaging each month of the first quarter. The U.S. needs to create a minimum of 100k jobs each month just to offset the number of new entrants. If the Fed wants to avoid seeing more workers dropping out of the workforce or an increase in the unemployment rate, they need to act now.

How Far Will the Fed Go and What Does it Mean for the Dollar?

· Low Rates Pledge Extended to Mid 2015 - Dollar Bearish

· Low Rates Pledge Extended Beyond Mid 2015 - Very Dollar Bearish

· Open Ended QE3 - Very Dollar Bearish

· Limited QE3 - Dollar Bearish, but Magnitude to Depend on Size and Length of Program

The only question is how far the Federal Reserve will go. We expect the central bank to alter the rate guidance language in the FOMC statement and extend their low rates pledge from late 2014 to mid 2015. We also believe there is also a greater than 75% chance that the central bank will announce QE3 outright and if not, at bare minimum set expectations for it to happen in October. The rate guidance change was mentioned extensively in the minutes from the last meeting. If the central bank pushes its low rates pledge beyond mid 2015, it will be very negative for the dollar. If the Fed delivers QE, the dollar would also extend its losses but the magnitude of the sell-off would depend on the size and scope of the asset purchase program. Open-ended QE would be very bearish for the dollar and a low probability scenario. Instead, a QE program will mostly likely be at a set amount and the smaller the commitment in terms of size and time, the better it is for the dollar. The benchmark will be QE2, which was $600 billion over a 7 or 8 month period. If the Fed were to announce QE3, there's no doubt that the asset purchase program will extend beyond the elections and the fiscal cliff hump.

At one point, the U.S. elections in November would have mattered to the Fed but after 5 months of weak job growth, no one can criticize the central bank for taking aggressive steps to reinvigorate the labor market. Partisanism or not, the U.S. economy needs help and the Fed can't stand by idly and do nothing for the next three months until the elections are over. Don't forget that this month, the Fed will not only deliver its rate decision at 12:30pm ET (4:30 GMT), but also release its latest economic forecasts at 2:00pm ET (18:00 GMT) and hold a Bernanke press conference at 2:15pm ET.

How Has the U.S. Economy Performed Since Last Fed Meeting?

While we expect the central bank to ease, it is important to acknowledge the improvements in the U.S. economy. The following table illustrates how the economy and more specifically, economic data, have fared since the last Fed meeting in August. For the most part, there have been more improvements than deterioration. Most notably, consumer spending rebounded significantly in July, but the data is a bit stale as more recent numbers are due for release on Friday. Consumer confidence, on the other hand, is mixed due in large part to lackluster job growth. Two non-farm payrolls reports have been released since the last FOMC meeting and on August 1, the central bank had on hand a very weak labor market report. Thankfully, inflationary pressures have been muted and there are signs of life in the housing market. Manufacturing and service sector activity is relatively unchanged, but businesses and consumers should feel more optimistic with the rise in equities. Despite the improvements in economic data, we still expect the Fed to ease, because at the end of the day, the data is underwhelming and if the Fed wants to reverse the course of the labor market and jump start the economy, it needs to act now.

(click image to enlarge)

FOMC Table

Source: FOMC Preview: Potential Impact On Dollar