Market rallies in fixed income and equities, as well as better-than-expected economic data, should reduce fears that the US economy is mired in an extended period of below-trend growth that will push the unemployment rate back up above 10%.

The only action the Fed has taken since US economic growth slowed in the spring is to begin re-investing maturing and pre-paying MBS into US Treasuries to prevent its balance sheet from otherwise shrinking. The central bank, however, is having a much bigger impact on markets and growth prospects than such a minor action would suggest. Fed communications suggesting a near-term resumption of outright asset purchases has contributed to a significant move in market prices that should have a positive effect on the US economy in coming quarters. Since the US economy has been one of the laggards in the global recovery and remains the world’s largest, improved prospects for US growth have positive implications for global markets more generally.


Risks declining for continued below-trend US growth

Most economists (including ourselves) lowered their forecasts for US H2 GDP growth following disappointing employment reports (beginning in May) and a much lower-than-expected Q2 GDP report released in July, which included significant downward revisions to consumer spending in previous quarters. Indeed, many (but not including ourselves) projected that the below-trend growth recorded in Q2 would continue into next year, implying that the unemployment rate would reverse its recent decline and move back up over 10%.

Recent market moves and economic data, however, have reduced the likelihood of an extended period of below-trend growth. The report on September retail sales – which was better than expected and included upward revisions to previous months – suggests that consumption is accelerating, currently tracking around 2.9% in Q3 after growing around 2% in the first half of the year. Trade data through August imply that while net exports are likely to continue to subtract from growth, the size of the drag will be nowhere near that of Q2 – which amounted to a staggering 3.5 percentage points (Figure 1).

And while employment data have continued to disappoint, higher frequency data on jobless claims have shown no tendency to deteriorate, casting doubt on forecasts for a resumption of a rising unemployment rate (Figure 2).

Overall, Q3 GDP growth is tracking slightly stronger than our forecast of 2.5%, confounding expectations of another quarter of sub-2% growth.


Market rally and dollar decline boost US growth prospects

Meanwhile, markets have rallied strongly and the dollar has fallen since the Fed began to open the door for further QE with the FOMC statement following the August 10 meeting (Figure 3).

Bond yields are now a full percentage point below first-half averages (Figure 4), contributing to sharp increases in mortgage refinancings and corporate bond issuance.

Stock prices have risen some 10%, which boosts household wealth and should provide some support to spending and confidence. Finally, the trade-weighted dollar has fallen by roughly 5% since August (and close to 10% since its peak in early June), which will provide a boost to trade (and inflation) over time.


QEII jolt to markets is temporary

A healthy dose of caution is in order, however. To the extent that market moves are being driven by expectations of significantly more QE, those expectations can be disappointed, and any QE that does occur provides only a temporary boost. Markets will eventually anticipate a withdrawal of the extraordinary liquidity that the Fed has been and is likely to continue to provide. It is also worth noting that mid-term elections and outcomes on tax policy present risks in both directions.

This week’s data releases from other countries were largely unremarkable and did not do much to change perceptions. The most notable news came out of China. Reserve requirements were hiked at the beginning of the week for the fourth time this year, but this action is unlikely to restrict credit growth significantly. Indeed, reports for September indicated that new lending moved up further and confirmed that FX reserves rose sharply in Q3, reflecting a surge in capital inflows. Trade data for September showed a modest decline in the surplus, reflecting a slowing in export growth. The RMB continued to appreciate against the dollar at a more rapid pace than had been observed in the latter part of September, but overall it has appreciated less than other currencies have (ie, the RMB has depreciated on a trade-weighted basis). Notably, European policymakers and politicians ramped up their criticism of China’s currency policy in recent days, reflecting the marked depreciation of the RMB against the EUR. Bottom line: tensions around China’s currency policy persist, and continued dollar depreciation only adds to that pressure, as other policymakers do not welcome appreciation in their own currencies.

source: BarCap