What to make of the U.S. resurgence

January 12, 2011

-Kathleen Brooks isUSA-DOLLAR/ research director at forex.com. The opinions expressed are her own.-

Back in the summer, things in the U.S. were so dire that the Fed had to step in to the breach and boost the economy with a $600 billion cash injection. This was only formally announced in November, yet within two months the outlook for the U.S. economy has brightened markedly. The dollar has had a flying start to the year and appreciated more than 2 per cent against the other major currencies.

But is this reversal in fortunes too good to be true and can the huge juggernaut of the U.S. economy really turn around this quickly?

The chief reason for the boost in investor sentiment, particularly towards the dollar, is the uptick in some of the major U.S. economic indicators. The widely watched ISM surveys have jumped in recent months and there are positive signs that the recovery that was noticeable in the manufacturing sector of the U.S. economy is now spreading to the much larger services sector. Investment houses rushed to revise higher their growth forecasts at the end of last year after President Obama agreed to a two-year extension of the Bush tax cuts. All of a sudden the U.S. economy was hitting the headlines again for all of the right reasons, and after giving the dollar a wide berth for most of the second half of 2010 investors are once again happy to own the greenback.

The U.S.’s economic outlook is even brighter when it is compared to its western counterparts. The euro zone and the UK face a year of tax hikes and austerity measures designed to reign in budget deficits, which should keep a lid on growth. Already at the start of the year we have seen the UK services sector slip back into contraction and Europe’s core economies are leaving the weaker peripheral nations in their wake when it comes to the growth stakes. In the last months of 2010 investors were willing to support the euro on the back of a bright outlook for the core economies, but not so in 2011 – the motto seems to have changed for investors to one of “the euro zone is only as strong as its weakest members”, which at the moment means it is extremely weak. So part of the dollar’s attraction is relative: at the moment its future is brighter than its neighbours’.

But, the U.S. is far from out of the woods itself and investors could be accused of lowering their standards. Jobs growth is mediocre at best and it will take many more months of 100,000 per month job creation to bring down the unemployment rate to a level more acceptable to the Federal Reserve. This doesn’t suggest the U.S. is in rude health. Due to these headwinds, we don’t think that the U.S. growth path will follow a straight line. But if we get another economic hiatus like the one last summer, will the Fed be able to provide another round of quantitative easing? Probably not that easily.

So while the near-term outlook for the U.S. economy is one of gathering momentum lending support to the dollar, the very policy measures that are supporting growth now will hurt it later. Quantitative easing and the extension of the Bush tax cuts are only exacerbating the U.S.’s unfathomably large debt mountain – at last count it stood at $14 trillion. The U.S. needs to sort out its debt problems at both a federal and state level (California has a budget gap this year of more than $20 billion). This means a lower dollar for the long term and higher inflation to try and erode the debt load.

Whereas Europe is tackling its problems the U.S. appears to have no real will to do so. Thus, it doesn’t take a genius to see that it’s only a matter of time before the bond vigilantes come-a-knockin’.

The U.S. economy may bask in the sun today, but the clouds could come out tomorrow.

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