Rally cry for a US revival

The US economy is entering a new, surprise cycle of solid growth, raising the prospect of a lower Australian dollar and Reserve Bank hikes before the year's end.

The upward momentum in the US economy is gaining more traction. In fact, 2013 looks like it will be a year where GDP growth moves to an above trend pace for the first time in six years, where the unemployment rate will slip towards 7 per cent for the first time in over five years and where the budget deficit will narrow sharply as the automatic stabilisers and policy changes kick in.

To be sure, there are a smorgasbord of risks ahead, but the economic data flow and market moves in the early months of 2013 have almost universally surprised on the upside.

The stock market is locking in record highs, which is delivering a quite massive recovery in consumer wealth and with that, purchasing power. This is being accompanied by strong job creation to the point where there are clear and sustainable inroads being made into the unemployment rate. House prices are also on a march higher, which will be of comfort to mortgage holders and their banks alike.

In the US, there were 236,000 jobs created in February, smashing expectations for a rise of 170,000. Since the start of 2012, 2.55 million jobs have been added and encouragingly, in three of the last four months, there have been increases of 219,000 or more.

This solid rate of job creation means that the unemployment rate has fallen from a peak of 10.0 per cent to now be at 7.7 per cent, the lowest rate since December 2008. At the same time, the average work week is increasing and wages growth is ticking higher, both critical elements of improving demand for labour.

The US stock market is responding as anyone’s good old text books and rational observers would expect – it is rising strongly.

The S&P500 is up a thumping 130 per cent from the low point in 2009 and it is scaling new highs as investors look for the economic improvement to lift corporate earnings, profits and investment. At the same time, government bond yields in the US are creeping higher, despite the $85 billion of monthly purchases from the Federal Reserve as it deploys all elements at its disposal to make sure this economic recovery is sustained via low interest rates.

The yield on the 10-year government bond has increased to 2.06 per cent at present, an 11-month high and well above the frightening lows of 1.45 per cent recorded during the third quarter of 2012 when the fiscal cliff, threat of a eurozone break-up and prospect of a Mitt Romney presidency spooked markets.

All of this matters for the world and Australia.

Despite the deep recession between 2008 and 2010, the US is still by far the largest economy in the world, accounting for around 20 per cent of global GDP. The US economy is still roughly double the size of China. A 1 percentage point upside surprise in US GDP growth would be felt around the world. The US also has by far the largest, deepest and most liquid financial markets so a healthy US economy and buoyant markets are essential if the world economy is to do well.

This good news is one important reason why the Australian economy is about to kick into a stronger growth phase over the next 12 to 18 months. It means that the Reserve Bank will probably not be cutting interest rates again in this cycle and if the good news from the US percolates throughout the world and back into Australia, interest rate hikes could be on the agenda before year end.

This scenario would be further enhanced if the stronger US economy translates to an appreciation of the US dollar. A stronger US dollar would normally see the Australian dollar fall and this has already happened to some extent, with the Australian dollar currently around $US1.0250 from levels around $US1.05 of $US1.06 just a few months ago.

While this fall, to date, is moderate and could easily be reversed, a break towards $US0.95 or less would be a fillip for the non-mining export sector and the local firms struggling to compete with importers. This is the other upside from a strong US economy.

It might be premature to be completely confident that this bullish US scenario will unfold, but in the first 11 weeks of 2013 the probability of a strong US economy is becoming more and more concrete.

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