US markets uncoupling from US reality

It looks like this quarter will show the strongest growth for seven years in the US but markets reacted poorly to the news. Why? Because strong growth means turning off the US printing presses.

On Friday in the US, there was some more unambiguously good news on the economic recovery with an unexpectedly sharp rise in job creation and confirmation that the unemployment rate was below 8 per cent for a second straight month. The rate of job creation, now running at an annualised pace of more than 2 million in the four months since June, is consistent with annual GDP growth of 3 per cent or a touch more which is well above the 2 per cent or less expansion recorded in the last 6 months. In other words, it seems likely that the GDP growth rate for the December quarter will be one of the strongest results in the US for almost seven years.

Yet this favourable economic news saw a 1.0 per cent drop in share prices, bond yields also fell, commodity prices slumped and the US dollar strengthened.

All of these market moves were intuitively wrong. A strong lift in job creation, a clear downward trend in the unemployment rate and other evidence showing an upswing in the beleaguered housing market and potentially stronger GDP growth should be sparking a stock market rally, a sharp jump in bond yields and rising commodity prices.

So what is going on?

It seems quite simply that the markets are operating with a cargo cult mentality. They have become so utterly dependent on public sector cash, including from the money printing machine at the Federal Reserve, that good economic news is seen as bad -- bad because it means the money tap may been turned lower or in a worst case turned off.

In other words, the market seems to be functioning from the perspective that if the US economic recovery comes earlier or is more robust that the US Federal Reserve (and others) are currently factoring in, the amount of policy stimulus needed will be less. Worse still, if there is a fully fledged economic pick up, the policy stimulus will stop and then reverse.

That’s the way, it seems, markets are viewing things at the moment; they would prefer to remain on the public sector money drip rather than back themselves in an economy that is registering decent growth.

The worrying thing from the perspective of the sustainability of the current economic recovery in the US is that the markets might be correct.

It can legitimately be argued that the only reason there has been a widening and accelerating momentum in the jobs market and why housing is starting to climb higher is the policy stimulus that has been in place. In other words, the near zero Fed funds rate, the quantitative easing and the promise to buy more bonds are driving the recovery rather it being built on anything the private sector is doing.

The Chairman of the Federal Reserve Ben Bernanke knows only too well the risks confronting the US, even though a raft of economic indicators are continuing to improve. That is why in the recent policy announcement, barely a month ago, the Fed said in no uncertain terms that "exceptionally low interest rates” (near zero in other words, would remain in place until at least 2015. It was also why he set new ground in the framing of QE by saying that the bond buying program, including for mortgaged back paper, would be $40 billion per month but that there was no end date to this commitment to support the mortgage market.

Any premature withdrawal of the policy stimulus would run the risk of stalling and even reversing the recovery. The market need not fret given Bernanke’s commitment, who as an academic studied the policy errors in the 1930s Great Depression. Bernanke (and others) have found that the depth and duration of the Depression owed much to the premature withdrawal of stimulatory monetary policy.

It is unlikely that the Fed, while Bernanke is chairman at least, will make the same mistake.

For Australia, an economic pick up in the US is terrific news, especially if there is a strong consumer element to the move to faster growth. While direct trade flows with the US are relatively small, a stronger US consumer who seems to be enjoying a rebound in wealth and a recovery in housing, is a large consumer of goods manufactured in China.

If US demand can increase, then Chinese demand for the raw materials that go into the manufacturing chain will also pick up. To date, there are few signs of sustained and broadly based commodity price lift -- on the contrary, commodity prices remain subdued. But a few more months of strong job creation in the US might spark a more favourable outlook for commodity prices into 2013.