Monday, 21 January 2013

Possible end of US economic weakness and Fed accommodation

Matthew Boesler at Business Insider reports the views of several analysts who think that the period of weak US economic growth may be coming to an end.

In 2009, Mohamed El-Erian, CEO of PIMCO– the world's biggest bond fund manager – coined the term “new normal” to describe the period of economic malaise the U.S. would experience in the wake of the biggest recession of a generation...

On Thursday, El-Erian told CNBC that the “new normal” may soon be over...

Société Générale economist Aneta Markowska agrees, and she thinks it could happen in the first half of 2013 – even sooner than most expect.

An end to economic weakness would mean a potential tightening from the Federal Reserve. This will have implications for markets. From a note to clients by Markowska:

On the Fed, we are still leaning toward a year-end termination of asset purchases. However, as the markets try to front run the Fed, the watershed moment could come long before then. Consequently, we are revising our forecast for the 10-year Treasury yield and now look for a 2.2% target at the end of Q1, and a year-end target of 2.75%.

Indeed, Bloomberg reported at the end of last week that some Fed officials have become concerned about overheated markets.

Federal Reserve officials are voicing increased concern that record-low interest rates are overheating markets for assets from farmland to junk bonds, which could heighten risks when they reverse their unprecedented bond purchases...

“Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels,” [Kansas City Fed President Esther] George said in a speech last week. “We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances.”

Bernanke himself raised that concern this week, saying the central bank has to “pay very close attention to the costs and the risks” of its policies during a Jan. 14 discussion at the University of Michigan’s Gerald R. Ford School of Public Policy in Ann Arbor...

The first sign of Fed tightening may set off a hair trigger in the bond market, said Drew Matus, senior U.S. economist at UBS Securities LLC in Stamford, Connecticut.

“There is no pulling back a little,” he said. When the Fed begins to shrink its portfolio, investors will start to price in the entire stock of bonds coming back into the market. “It is always going to be hard to disengage in a very gradual manner.”

There are some who think that the Fed will remain accommodative though.

“They are still mostly in the mode of looking to support the economy,” said Phillip Swagel, a former assistant secretary for economic policy at the U.S. Treasury who is now a professor at the University of Maryland’s School of Public Policy in College Park.

“For them to take action to head off financial sector froth when the economy is still weak is very difficult,” Swagel said.

Bill McBride also does not see the Fed tightening soon. Despite being “pretty optimistic” about the economy and forecasting no recession in 2013, he thinks that the economy will be “sluggish with all the austerity”. With inflation also not an immediate concern, he thinks that “the Fed will probably stay accommodative for a few more years”.

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