|Summary: Rumours that the US Quantitative Easing program will end soon are premature, but they are gaining momentum and are likely to spur a short-term market correction.|
|Key take-out: Weight of money and the ‘Great Rotation’ won’t be under threat for some time – even if the US economy strengthens.|
Key beneficiaries: General investors. Category: Portfolio management.
In my piece of January 18, The risks that matter in 2013, I noted the possibility that Quantitative Easing might end this year as a key risk for the market.
At that stage we’d already had murmurings from some Fed participants, who wanted exactly that. It’s a critical point for investors because, if you recall in 2011, mere rumours that QE could be pulled contributed to a 10% rout on the S&P500. Indeed talk has already rattled traders in the gold and precious metals space – and gold so far is down 7% from its 2012 peak.
Now while talk of an end to QE is no more that quiet banter at this stage, it won’t take much for it to pick up and, indeed, the slow drum beat is already getting faster. So we need to watch this very closely given the possible repercussions. One Federal Reserve Board governor only last week noted that there were already signs that credit markets were beginning to overheat. Similarly, the President of the Federal Reserve Bank of St Louis (who is a voter on the Fed’s monetary policy committee) said that he would be in favour of ‘easing back on the throttle’ perhaps in the middle of the year if data remains strong.
The thing is, current momentum suggests the data will most certainly remain strong, which means that on face value, QE being pulled in is extremely likely. This is despite what was notionally a weak US GDP result in the December quarter. Why? Because that weak GDP result was largely due to the biggest fall in defence spending in 40 years, not something that is going to be repeated with China on the rise. Private demand in contrast was up 2.7% (3.3% year-on-year). This compares to 2.6% in 2011 and 1.3% in 2010 and the pre-GFC average of 2%. Pretty good momentum and there are few headwinds to an acceleration.
Then there was the January jobs report. The Fed has made jobs a key criteria in ending QE and has ruled out lifting rates until the unemployment rate drops below 6.5%. To end QE, senior Fed officials have said they would need to see a ‘substantial improvement’ in the labour market. And while we don’t know what their definition of substantial is, if the current trajectory is maintained, it’s going to be hard to argue the US labour market isn’t on that path. Indeed it’s already clear that the Fed’s forecasts are looking little on the pessimistic side.
Total economic growth was projected as late as December to be 1.7% or so in 2012. We already know it was stronger at 2.2%, with private demand even higher than that as mentioned. Similarly, while the unemployment rate matches their December projection, they’ve been revising that down all year as jobs growth surprised them on the upside. Mid-last year the Fed thought unemployment would be from 8%-8.2% now. For 2013, they expect something in between 7.4% and 7.7%. To see why this is probably too high, consider that you’d only need very moderate employment growth of say 50,000-75,000 per month and a modest fall in unemployment to see that forecast achieved. On current trends the unemployment rate will be closer to 7% by year-end. That would constitute, on any reasonable assessment, a substantial improvement in the labour market.
That’s not to forget the positive feedback loop that strong jobs growth provides. We had something like 2.4 million jobs created in the US last year. At an annual average wage of $40,000-$50,000, that’s an additional 1% or so of GDP just there. Then there’s the confidence-boosting impact a stable or even growing labour market has on spending. When people aren’t afraid of losing their jobs, out they go and spend. Finally, we can’t overlook the strong support to the economy that population growth is providing. The US added 3.6 million people in 2012, which is the third-largest increase since the 1940s and the largest in 12 years. Typically when you see strong population growth like this in one year, it’s followed up again over the next year or two.
Now, with all that said and done, I don’t think the Fed will actually halt QE (noting it is still a significant risk). To see this, consider that Fed purchases of debt securities to date have virtually, if not entirely, matched the government’s budget deficits since the GFC (shown in chart 1 below).
This is maybe not exactly in any given year, although that does happen. So the Fed pretty much fully funded the US federal deficit last year of $1.1 trillion, depositing around $1 trillion into the accounts of primary dealers (who then in turn bought treasury securities from the government, selling a portion of those back to the Fed). It was a similar story in 2011, and in the two years prior to that.
In 2013, the Fed’s intention is the same. The Fed will purchase $85 billion per month in new securities, which equates to around another $1 trillion. Now, while this is above the estimated deficit for the year, you can see from Chart 1 that the Congressional Budget Office forecasts material deficits all the way to 2015, with only a modest improvement in 2015-16, before another rapid deterioration. And that’s with its working assumption that interest rates don’t change much over the next three years.
This, ultimately, is why I doubt that we will see QE end even if, in the likely event, economic data continues to print on the strong side. This is especially if I’m right about that substantial improvement in the labour market. The Fed, in reality, has been funding the government’s budget deficits since the GFC began, and unless we see genuine reform on this front, I don’t really see the Fed changing course.
So watch out for increased chatter about the end of QE. But chatter is all I think it will be. Weight of money and the ‘Great Rotation’ won’t be under threat for some time – even if the US economy strengthens.
That said, the conversation will act to restrain markets, if not cause an outright correction (depending). But that’s a storm I think investors should wait out. On my analysis, the most likely course of action is that the Fed will provide a “pleasant surprise” to the market, and only reduce QE slightly to say $70 billon per month from its current $85 billion. About that is what is required to meet this year’s budget deficit.