ECB Cut Still Possible Despite Firmer Recovery‏

The data released over the holiday season suggests that the recovery has strengthened substantially in the US but also in the euro area, where it is increasingly spreading to the area’s peripheral countries. Emerging markets continue to be fragile, although so far they have weathered the Fed’s tapering decision relatively well. Risk sentiment has continued to be positive despite 2014 starting with a modest correction. Stock markets and bond yields have continued to edge higher, with emerging markets continuing to underperform.

Strong US data justifies Fed’s tapering decision
The data released since the Fed announced that it will start tapering on 19 December has in general been better than expected and confirms that the recovery in the US gathered momentum in Q4 13.

Private consumption appears to have been very strong in Q4. Personal spending increased by a solid 0.5% m/m in November after increasing 0.4% in October. Preliminary reports on the important Christmas retail sales have also been encouraging.

The housing market appears resilient despite higher mortgage yields and the uncertainty surrounding the federal government shutdown in October. According to the Case-Shiller survey for the 20 largest cities in the US, gains in house prices accelerated slightly in October and were up 13.6% y/y. Nonetheless, the possible negative impact of higher bond yields in the US housing market remains a significant risk to the recovery.

Finally, there are signs that corporate investments might be improving. Durable goods orders in November improved markedly by 3.5% m/m. So far, corporate investment has been absent from the recovery.

Manufacturing remains strong. While ISM manufacturing in December declined slightly from 57.3 to 57.0, it remains at a high level and the details in December were strong, with new orders improving and inventories being cut at a faster pace. Notably, the discrepancy between the strong surveys and the more subdued industrial production data has also started disappearing, with growth in industrial production picking up.

So far, there is nothing in the data to suggest that the Fed will diverge from the tapering path it indicated at its 19 December meeting, which suggests that it will cut its monthly bond purchases by around USD10bn at each meeting. With the US recovery gathering momentum, we expect the rise in US bond yields to continue but we expect yields to rise at a moderate pace as the Fed keeps strong forward guidance, ensuring low rates for some time.

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