Fundamental Update: Initial thoughts on the FOMC decision

Financial markets can't seem to decide if this evening's Fed announcement is good or bad news for financial markets. Here is what the Fed has decided to do:

1, QE3: this will entail purchases of $40 billion of mortgage-backed securities each month - these purchases are unlimited and will depend on future labour market data.

2, The pledge to keep interest rates at 0-0.25% has been extended to 2015.

3, There will be more Operation Twist, focusing on extending the banks' ownership of long-dated Treasuries by selling short-term government debt. It expects to boost its holdings of long-term debt by $85bn per month.

So what does this mean for traders?

Overall this is mildly disappointing. The markets got the QE it wanted, the mortgage market has been targeted and the purchases are unlimited. However, some expected QE purchases to be at least $50bn per month, so this action may not be the Fed's big bazooka.

The key take-away from this meeting is that the longevity of QE3 is completely reliant on labour market data. The Fed stated clearly that "If the outlook for the labour market does not improve substantially then the Committee will continue its purchases of mortgage backed securities, undertake additional asset purchases and employ its other policy tools as appropriate until such improvement is achieved". The Fed's focus is squarely on the labour market and if we get more disappointing readings of Non-Farm Payrolls then we could see bigger MBS purchases in the coming months.

The question some may be asking now is, what does the Fed have left if low interest and mortgage rates don't hep to spur the labour market? By pinning its hopes on the housing market the Fed is hoping that hiring in the construction sector will help to reduce the unemployment rate. Thus, going forward the markets are likely to be uber-sensitive to 1, labour market data including the unemployment rate, NFPs and also initial jobless claims. 2, housing market data.

So how did the market react?

•  The euro is range bound between 1.2860 - 1.2965, likewise, USDJPY has recovered after dipping as low as 77.13 on the announcement.
•  Gold is higher, above $1,750 for the first time since February this year.
•  US stocks are higher - including banks
•  Treasury yields are higher on this, suggesting that the market may have been priced for more aggressive Fed action. It also doesn't help the Fed's cause to keep downward pressure on long-term interest rates.

Potential long-term reaction:

•  The dollar is likely to remain range-bound for now, we don't see a sharp sell-off neither do we see the buck gaining ground as QE3 may keep a lid on greenback gains for the medium-term
•  Gold may well be the biggest winner from this, as the Fed's pledge to do "unlimited" agency asset purchases could be inflationary, especially if we see labour market data pick up in the coming months. $1,800 is on the horizon in the coming days and weeks.

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

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