US data may test the tapering resolve in coming months
This, in a nutshell, is the message from our recent look at US manufacturing data. The point here is not that forward looking indicators are currently justifying a very negative outlook; clearly that is not case. The point is that with growth indicators already largely normalised the challenge is now to maintain momentum. With expectations still fairly bullish on the US economy there is room for some slight disappointment in coming months.
The last seven months have seen an impressive improvement in US manufacturing. Almost all components of US manufacturing have been growing strongly and the US ISM has staged an impressive comeback from sub-50 in May last year to 57 in December. However, our growth diffusion index now implies the potential for short-term disappointment.
The most interesting thing in this regard is how it will affect the very finely balanced QE exit strategy that the Fed has currently put into place. For example, economists polled by Bloomberg do not expect Friday's poor non-farm payroll number to put a dent in the Fed's tapering plans.
I agree on the importance of the non-farm payroll report; no serious economist would ascribe any importance to one reading (especially not with the strong ADP report). If this was indeed weather related the only thing we can say is that we are in for another "blip" in January as the big freeze is sure to exert notable distortions on 1Q14 data.
However, a more interesting question is how this will alter Fed communication and action. We know QE is conditional on the data so we now get to survey just what that conditionality means. Another critical point is how the Fed will adjust to the rapidly declining unemployment rate. We will thus hit that 6.5% anytime now. So does that mean that the Evans rule is massaged down to 5.5%, does it mean rate hikes(!?) or just that tapering will continue? How will the market price this on the short end? These are key questions that we are yet to answer and which can only be answered in conjunction with how serious the Fed is concerning its resolve to exit QE and how sensitive it is to US economic data.