How many balls can a juggler juggle… 5, 6 ,8, 10, 12?

Perhaps a better question, is at what point does the juggler face diminishing returns.

The relevance to the financial markets can be traced to the current role of the US Federal Reserve. In an attempt to prevent a recession, or at the very least, keep damage to a minimum, the US Fed – and the Bank of Canada to a lesser extent – have tossed a lot of balls into the air. Each new ball bringing the concept of diminishing return closer to home.

We saw evidence of that on Tuesday. Traders reacted to the latest ball with a 400 point up day for the Dow Jones Industrial Average.

The latest ball came in the form of a giant swap. Which is to say, the US Fed swapped high quality treasury securities for “high quality” mortgage backed securities. Since the latter had no secondary market, the swap provided banks with liquidity.

The hope is that enhanced liquidity will find its way to credit worthy borrowers. A segment of the market that so far, has not been well serviced. To short circuit the recession banks need to step up their lending practices, and play ball. You can track the success or failure of this ball by tracking the spread between US mortgage backed securities and US treasury bonds.

Initially, equity traders liked what they saw. Another example of a Fed willing to do anything to ease short-term pain. But that may be the problem.

As the Fed throws the liquidity ball into the air, it skews the line of other balls already there. Namely the series of rate cuts that have already taken place. With another cut likely coming on March 18th!

The diminishing return debate centers on the unforeseen longer term impact of trying to fix a short-term problem. Interest rate cuts, liquidity infusions in the form of swaps, increases in money supply and tax cuts, lowers the value of the US dollar.

A weaker US dollar negatively impacts US wealth, gives support to further increases in the price of oil (i.e. oil is traded in US dollars), and longer term, leads to inflation. You might argue that a lower greenback should help the US trade deficit, but so far, we have not seen that. Most likely, because of the US markets thirst for imported oil.

What is clear and likely to remain in place for some time, is increased volatility. The Dow up 400 points on Tuesday, down 48 points the next day. A 300 point swing from top to bottom on Thursday. All of it impacting Canada, albeit to a lesser degree.

To me, we will continue to be locked in a trading range. With more balls in the air, the range may expand, which should add to volatility. Which is to say, option writing strategies should continue to do well. Or at the very least, beat a buy and hold strategy.