Fed's Scaling Back Of QE: Timing Key To Its Success

The much anticipated June payroll figures have been excellent, with a gain of 195,000 jobs in June and a revision of April and May jobs to 199,000 and 196,000 respectively. Suddenly, the US employment has started to appear very strong, weathering the fiscal concerns and higher taxes, with the past 3 months' average figures close to 200,000. The unemployment rate, however remains unchanged at 7.6%. The US markets rose sharply on the news with S&P 500 gaining 1% to close at 1,631.89 on Friday while the Dow Jones Industrial Average, added 1% to close at 15,131.89. The 10-year Treasury yield jumped 10bp from 2.56% to 2.66%, reaching its highest level since August 2011. THE US dollar hit a 3 year high with USD/JPY hitting 101 and EUR/USD made its way towards 1.28. The stocks remained volatile through the day on Friday with investors weighing the improving job numbers against Fed's possible stimulus scale back worries. The Fed chairman Ben Bernanke, during last month's FOMC meeting, indicated that the central bank is considering, turning the tap off the on-going $85 billion a month asset purchase program later this year.

Ever since the QE3 stimulus program was initiated by the Federal Reserve, during last September, the investors have been on an aggressive stock buying spree, which continued through the majority of the first half of 2013, when the major indices reached record levels on May 22nd 2013; with Dow index touching 15542 points; while the S&P 500 at 1687. Since then the rumors of the Fed strategizing the stimulus exit, have created enormous volatility in the market, which continued to gather strength, when the Fed eventually confirmed that it would indeed scale back the on-going stimulus, later this year. The investors reacted sharply to this shocker by the Fed, and most investors opted to take the profits and the month of June remained very volatile with most investors opting to stay out of the market, and have been long awaiting the June non-farm payroll figures, to foresee any possibility that the Fed would delay its tapering plans.

But although job numbers are good, everything is still not right with the US economy. While the employment figures have been exceptional, the percentage unemployment level of 7.6 % is still very much a worrying factor. For the years 2007 and 2008, the average unemployment was around 5% as compared to the current levels of 7.6%. Although the employment rates have come down from its highest levels of 10%, recorded during October 2009, the inconsistent labor participation rates have distorted the figures. According to the Bureau of Labor Statistics, "The number of unemployed persons, at 11.8 million, and the unemployment rate, at 7.6 percent, remain unchanged in June. Both measures have shown little change since February." This is of a serious concern as no matter how much progress was done with regards to the increase in the job numbers, more labor participation rate pouring in each month, has prevented the rates to come down, as quickly as expected. The Federal Reserve cannot overlook this figure and start scaling back, before they could bring this down to below 7% with some consistency in order to stabilize it. The labor participation rose to 63.5%, from 63.3% earlier in the year, the lowest level since 1979. This is likely to make things difficult for the Fed to forecast the speed at which the unemployment rate may come down to an acceptable level; i.e. up to 7%, to rightly time the stimulus cuts back.

The Fed must also need to ensure the US GDP, which disappointed in the first quarter of 2013 (revising down to 1.8% from 2.4%), moves up quite considerably at least the next couple of quarters, before taking any drastic steps on scaling back the $85 billion monthly asset purchase program. The GDP must grow close to 2% for the year so the growth could be sustained when the scale back of the stimulus occurs. The last time we saw a GDP of 2% or above was in 2005. The Federal Reserve's money pumping into the economy had the effect of masking the $85.4 billion cuts in government spending, so far for 2013. With similar cuts to follow in 2014 through 2021, taking away the monetary support might result in the actual realization of the impacts of these cuts which could have adverse effects to the overall growth of the economy.

Outside the US, alongside the emerging markets, the repercussions due to any monetary tightening in the US, will be greatly felt in the Eurozone, and this was quite evident when the German DAX tumbled by 2.36%, upon the release of Friday's Payroll data, anticipating the solid job numbers will force the Fed to unwind the on-going stimulus sooner. The European central bank during the policy meeting last Thursday issued a forward guidance policy and promised to "keep the interest rates low for an extended period of time" also assuring an accommodative monetary policy, for as long as necessary; stressing to rely on their "two pillar strategy" oriented policy - achieving price stability, striking balance between the inflation and monetary dynamics. The latest political crisis in Portugal sends a reminder that the Eurozone crisis is far from over. Even after the fiercest austerity drive in Portugal, the economy remains weak with the unemployment levels soaring at 17.6%. The political uncertainty has threatened to upset the progress of the country's €78 billion bailout program. Greece, on the other hand has been failing to meet critical deadlines to qualify for a €8billion (£6.9 billion) tranche of bailout money. More worrying is the fact that Germany's own economy is hardly booming with unemployment levels yet to pick up convincingly and the country's factory orders falling short for a second straight month in May, dropping 1.3%. Economists had expected growth out of Germany's industrial sector, and the unexpected fall is a sign that the on-going Eurozone crisis is disrupting the recovery in the Europe's largest economy. The OECD forecast the Eurozone economy will shrink by 0.6% this year. With Germany, getting ready for the elections in September, the Eurozone political uncertainty coupled with the looming US monetary tightening could dent the confidence of the 17 nation bloc and may potentially lead to a further deepening crisis within the Eurozone, which in turn may have grave impacts on the US growth.

China slowdown is another big concern for the US, as the growth in second largest economy in the world, fell short of analyst expectations and according to a Bloomberg survey, the ongoing credit crunch will reduce the credit growth by 750 billion Yuan ($12 billion), an amount equivalent to the size of Vietnam's economy. Given Bank of Japan and Bank of England are also persistently pursuing quantitative easing, the Fed should ideally take the global factor into consideration, before making any brave moves.

So the important question is to ask whether the US economy can handle the reduction in stimulus later this year? Although I'm a firm believer that the real economic growth can only be realized once we move out of the stimulus, the timing of the exit remains very critical. Even though the Federal Reserve has convinced the markets, that the scale back would still mean the Fed continuing with the monetary support, albeit on a lower stimulus, the central factor remains how well the Fed could anticipate what's going on within as well as outside the US. The success of the unwinding also depends on how flexible the Fed remains on reversing the cuts, if the economic conditions worsen, due to lack of sufficient liquidity. We should also not forget any sovereign defaults could be withstood only if the economy is strong enough to handle it. So the Fed would be eager to test if the US can withstand stimulus cut down and absorb peripheral shocks if any, by opting only a minor cut initially - whenever they opt to implement it. It should also anticipate the nature of the assets involved in the taper, i.e; whether the Treasuries or Mortgage Backed Securities or a combination of two and how to pace it to strike the right balance - any mistake in strategy and timing will have lasting effects on the economy.

Stock market correction is inevitable during the scaling back of the asset purchases, which is fine. But there is a fine line between retaining the confidence among the investors or creating a total panic, leading to a reverse in whatever economic growth achieved so far. The earnings season which kick starts next week should give the investors further insight into the health of the US economy.