Risk markets and bond markets have weakened – sharply in the case of equity markets – since late May when Federal Reserve (Fed) Chairman heralded that if the US economy continued to strengthen the Fed could start to reduce its monthly bond buying program (QE) over coming policy meetings. At its two-day June policy meeting the Fed provided more detail that if the US economy improves in line with its latest forecasts it could start to taper its monthly $US85 billion purchases late this year and would end the buying program by mid-2014. But Chairman Bernanke also stated clearly that tapering QE is data dependent, is a reversible process if the economy weakens and that any lift in official interest rates is still a long way in the future. Financial markets are reacting as if the Fed is about to engage in a conventional monetary policy tightening process normally aimed at slowing economic growth in order to contain inflation pressure, but the current plans of the Fed appear to be very different with no inflation problem to deal with and aimed at sustaining moderate economic growth for a long time to come.
The Fed wants US annualised growth to speed up from the current (Q1 2013) 2.4% to 3.0-3.5% in 2014. If that occurs, the Fed’s latest forecasts imply the US unemployment rate will still be above 6.5% at the end of 2014 and inflation still below 2.5% providing no cause for the Fed to consider lifting the zero Fed funds rate this side of 2015. The time-frame for both tapering QE and the start of lifting the Fed funds rate could extend much further into the future if the stronger parts of the US economy show any signs of faltering. Perhaps most at risk is the US housing recovery with the lift in the 30-year fixed mortgage rate from below 3.60% to almost 4.00% currently. Fed Chairman Bernanke’s stated view is that long-term mortgage rates rising for the right reasons – confidence that the housing market is improving and that house prices are likely to continue lifting – is unlikely to dent the housing recovery. Nevertheless the pace of the lift in longer-term interest rates has also drawn Fed comment about whether the rise is a reasonable response to the announcement that QE tapering may be coming later this year.
If the Fed becomes concerned that the lift in long-term interest rates could lead to a softer GDP growth trajectory than the acceleration it is currently forecasting for 2014, on what Chairman Bernanke has said, QE taper would come off the agenda and might be replaced by QE extension. It is this sense that the Fed is prepared to dial its QE plans and ultimately its plans for the funds rate to ensure that the US growth accelerates for at least a year or more that makes the extent of the falls in risk assets seem an over-reaction.
The falls in Australian risk assets have been particularly big by international comparison, but the local story is not just one of a taking a lead from what happens in the US. These days, what happens in Australia’s biggest trading partner, China, is far more important. China’s economy is going through a softer growth patch, mostly driven by policy initiatives to deal with excessive residential property speculation, the shadow banking system and rebalance capital spending freeing up private businesses to take the lead from government spending. China has a good track record over the past two decades making changes to key economic drivers and there is no real reason to suspect that China will not achieve its stated annual 7.5% growth objective over the next decade. Resource project investment spending plans in Australia at their height in the second half of 2012, however, were based on the earlier period of double digit Chinese growth and are now being adjusted to the reality that the prospects for mineral prices will simply be high over the next decade, not extremely high as assumed for the economics of some projects.
The pull-back in resource investment spending plans is also coinciding with a vacuum in government ahead of the September election. The on again/ off again leadership issue in the Government calls into question whether the policy plans announced so far are their real policy plans and what would survive in any case on an increasingly likely change of government. From the perspective of foreign investors, there is a question mark over Australia’s economic prospects until growth in China stabilises and the Government’s leadership shenanigans have added another question mark. Not surprisingly the Australian dollar is sliding quite fast and foreign support for Australian risk assets has fallen away. In time, these problems will resolve. China’s growth is likely to stabilise in the second half of 2013. A Government with a lower house majority is likely to be in place by from mid-September and the fall in the Australian dollar is a boon for local companies. At some point later in 2013 Australian risk assets will bounce and probably very strongly.