Why QE's job is almost done

It's jobs, jobs and more jobs.

The US economic recovery has taken a giant leap forward with 195,000 people gaining jobs in June, the unemployment rate remains steady but is well below the recession peak of 10 per cent and the participation rate showed a ticking up for a second straight month. Also encouraging for the economic growth optimists was a lift in wages with average hourly earnings rising by 0.4 per cent in the month, a factor that will support consumer confidence and spending power. 

Making matters better in the US were upward revisions of 70,000 to the level of employment in the prior two months, which means the six-month moving average for job creation is a robust 202,000 per month.

The health of the labour market will be a defining issue for the US Federal Reserve and its chairman, Ben Bernanke, as they turn their attention to the microsurgery of phasing out the current mass quantitative easing and super-easy monetary policy. It will be a long road to eventually normalise monetary policy in the US, but with each extra snippet of favourable news, the easier and closer that goal becomes.

It is now strikingly obvious that the Fed will start scaling back its QE, the only questions are when will it start and how rapid the phase out will be. The markets know this and it is being reflected in the bond market crash of the last few months. That unfolding bear market for bonds saw the 10 year government bond yield jump 24 basis points on Friday in reaction the jobs numbers to 2.74 per cent. In less than three months, the 10-year yield has risen a thumping 100 basis points and it is double the record low 1.40 per cent registered less than a year ago.

There is now no doubt yields will keep rising as the market negotiates its way around stronger economic growth, higher inflation and the absence of QE from the Fed.

The stock market had a fire lit under it with a 1 per cent gain on Friday. This saw the S&P 500 close just 2 per cent from a record high and all of the market foibles that surrounded Bernanke’s discussion of a scaling back of QE is seemingly now forgotten. Companies build profits and earnings when the economy is strong  and the market is slowly realising this to be the case in the US at present, even if monetary policy is about to be tightened.

The solid employment result fits with a range of other positive news on the US economy.

Having been smashed into depressionary conditions, housing continues to move higher with prices, construction and builder confidence all lifting appreciably over the last two years. Consumer sentiment is also at five and six years highs and private demand, the engine of growth is running ahead strongly. 

The improvement in economic conditions is such that the Fed is likely to be a little more forthcoming in the weeks ahead with its rhetoric surrounding the phasing out of QE. It would not be surprising to see a scaling back of the $US85 billion a month of bond buying starting soon, perhaps in the next couple of months.

A strong US economy has a range of other implications.

For the economy, it is hugely favourable. The US is still the largest economy in the world and if it can register a decent expansion, this will inevitably spill over to the likes of Chinese and European manufacturers and will likely see demand for some commodities increase.

For markets, it will probably mean the US dollar appreciates and with that, the likes of the Euro and the Australian dollar will fall further. This is happening already and in the wake of the US jobs data, the Australian dollar fell to a new three year low of US$0.9065, while the Euro is trading at 1.2825.

The US recovery from the Great Recession continues to unfold. It has been slow but has been driven by a range of quite radical policy settings. The bottom line is that these policies have worked and the economy is gaining self-driven momentum.

The time is fast approaching for these radical policies to be phased out and for monetary policy to start to normalise. We are not there yet, but it will be interesting to see when speculation is building about the Fed’s first rate hike in this cycle, simply because the time is near when zero interest rates will no longer be needed.