The Week In The US : Lots To Celebrate

The string of data was definitely positive this week. Thanks to Fed officials renewed pedagogy efforts, yields stabilised, but the June labour market report was too positive not to trigger rising yields again, even if it was not consistent with the unemployment rate reaching the threshold sooner than previously thought.

US long-term rates bottomed out in early May, with 10-year rates at roughly 1.65%. Then, expectations began to build that the Fed would slow down its monthly security purchases as part of the third wave of quantitative easing (QE3). Statements by Fed officials, the publication of the minutes of the April-May FOMC meeting, and Ben Bernanke’s Congressional hearing fuelled tensions, which were only amplified by the FOMC meeting at the end of June. Ben Bernanke seized the occasion to officially announce that the Fed members’ economic forecasts had led them to project a winding down of QE3 by the end of the year with a complete halting of the programme by mid 2014, once the unemployment rate had fallen back to 7%. When the market closed on June 25th, 10-year Treasury yields rose to 2.60%, the highest level since August 2011, when the debt ceiling crisis was resolved in extremis, costing the US its AAA rating.

Since then, Fed officials have renewed efforts to be more pedagogic, explaining that the Fed’s decisions continued to be data-dependent. Although for the moment they expect a sufficient improvement in the economy to wind down QE3 over the next several meetings, their position is susceptible to change. William C. Dudley, President of the Federal Reserve Bank of New York, noted that in the recent past, the Fed had been overly optimistic on several occasions, implying that downside risks were stronger than potential upside revisions to forecasts. In other words, the winding down process was more likely to be extended over time than moved forward.

Various Fed officials were also careful to explain that the ending of QE3 and the beginning of a new interest rate cycle were two distinct events. Given the current outlook, a full year separates the two events at least. From this perspective, they emphasised that their forward guidance has not changed at all: interest rates would not be raised as long as the inflation outlook – as measured by the personal consumption expenditure deflator – remains below 2.5% in the medium term, and the unemployment rate holds above 6.5%. Moreover, as Janet L. Yellen first pointed out mid-February, this 6.5% figure is not a trigger, and the Fed could decide to wait much longer than mid-2015 (the date when unemployment should fall back to this level according to most FOMC members) to tighten its policy.

To drive home the point, some Fed members went so far as to try to refocus attention on inflation rather than on growth. So far,according to the generally accepted analysis, the inflation rate is more a possible constraint for future Fed actions than a reason to act: the Fed would maintain an accommodative policy as long as inflation remained mild enough to do so. The statements during recent weeks, however, reinstate inflation as a central objective, just as important as unemployment. Inflation is bound to remain low, and the vast majority of Fed members do not expect it to reach the 2% target until 2015 at the earliest. If it were to slow further, boosting inflation would become a central objective for the Fed. And this would mean an even more accommodating policy.

These pedagogic efforts have paid off, at first. Although the uptick in interest rates was not reversed, the movement was checked at least. 10-year Treasury yield eased by about 10 basis points. The correction of 2-year rates was even stronger, which means the markets also understood the signal, replacing expectations of key rate hikes with a position more in line with the Fed’s. Yields on the highest-rated private bonds also declined more sharply. Although we cannot speak of a real easing of monetary and financial conditions, after the abrupt tightening following the upturn in interest rates, the stabilisation at a historically accommodative level was a good sign. But data published this week ended that nice break, even though it should not have.

The manufacturing sector is regaining confidence. The ISM index rose above the 50-threshold in June, driven up by its production and new order components, with a particularly strong rebound in foreign orders. The implied rebound in exports is not yet visible in the data, but international trade statistics for May are another sign of the US economy recovering faster than the rest of the world. The trade deficit indeed deteriorated markedly from April, reaching an annualised USD 748 bn (4.7% of GDP), as imports soared by 2.2% and exports were down by 0.8% m/m. The strength in imports was particularly marked for consumer goods (including motor vehicles), a sign of private consumption holding up, and for industrial supplies, a positive indicator for future US manufacturing production.

But the best piece of news came from the labour market report, with two months in a row of private non-farm payrolls growing faster than 200,000 a month, a slight acceleration in wage growth and an another increase in the labour participation ratio. As this development did and will continue to limit the decreased in the unemployment rate, the threshold set by the Fed will not be reached sooner than previously thought. But the immediate reaction from financial markets did not integrate that, as yield soared once more and the dollar kept appreciating. Some more Fed pedagogy is obviously needed!

BY Alexandra ESTIOT