Friday, December 19, 2014

The Fed Is Patient
Thank you, Janet Yellen! You didn’t disappoint me. You are still the “Fairy Godmother of the Bull Market!” As I’ve noted many times before, the S&P 500 tends to rise after Yellen speaks about the economy and monetary policy. The S&P 500 soared 4.5% on Wednesday and Thursday in response to the dovish FOMC statement and Yellen’s bullish press conference.

On Wednesday, I wrote:
However, the plunge in oil prices and the turmoil in the junk bond market might increase the likelihood that the Fed will delay the so-called "lift-off" of interest rates beyond mid-2015. "None and done" in 2015 is a distinct possibility for Fed policy. Let’s see what Fed Chair Janet Yellen has to say later today. I’m counting on her to continue to be the "Fairy Godmother of the Bull Market.”
On Tuesday, I wrote, “The FOMC might surprise us and keep ‘considerable time’ in the statement.” I noted that inflationary expectations are falling. I also wrote:
The distress in the junk bond market might also dissuade the FOMC from changing the "considerable time" language. In any case, Fed Chair Janet Yellen’s press conference on Wednesday afternoon could have a big impact on the markets. I’m still betting that she is the "Fairy Godmother of the Bull Market.”
On Monday, I noted that FRB-Chicago President Charles Evans, one of the Fed’s uber-doves, has called on his colleagues to be patient and to delay raising interest rates.

Wednesday’s FOMC statement confirmed my analysis:
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
The FOMC remains dovish and patient. It will be even more dovish and patient next year when Evans will be a voter. Two of the three dissenters (Richard Fisher and Charles Plosser) were hawks, who are retiring. The FOMC has to be concerned about the financial stresses caused by the plunge in oil prices and the strength of the dollar, as evidenced by the spike in junk bond yields and the selloffs in the bonds, stocks, and currencies of emerging economies. That’s why they are willing to be patient for a considerable time longer.
(Based on an excerpt from YRI Morning Briefing)

Monday, December 15, 2014

The Fed's Three Options
The Fed has three choices, as I’ve discussed in the past. Normalization would be great in theory. In reality, the odds increasingly favor “none and done,” more so than even “one and done.” While the labor market warrants tightening sooner rather than later, inflationary expectations are falling fast as oil prices plunge and the dollar strengthens.

On October 13, FRB-Chicago President Charles Evans gave a speech titled “Monetary Policy Normalization: If Not Now, When?” Back then he said:
Looking ahead, I am concerned about the possibility that inflation will not return to our 2 percent PCE target within a reasonable period of time. First, the recent monthly inflation numbers have been low, so there is not much upward momentum. Second, as I mentioned earlier, wage growth has been relatively low for some time. While wages don’t predict future inflation, the two often move together. And, third, it does not appear as if inflationary expectations are exerting much of an upward pull on actual inflation at the moment. ...

To summarize, I am very uncomfortable with calls to raise our policy rate sooner than later. I favor delaying liftoff until I am more certain that we have sufficient momentum in place toward our policy goals. And I think we should plan for our path of policy rate increases to be shallow in order to be sure that the economy’s momentum is sustainable in the presence of less accommodative financial conditions. I look forward to the day when we can return to business-as-usual monetary policy, but that time has not yet arrived.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, December 3, 2014

Dudley’s Spin
FRBNY President Bill Dudley gave a speech on Monday titled, “The 2015 Economic Outlook and the Implications for Monetary Policy.” His views matter because he is on the FOMC and reflects the views of the dovish majority of the committee. He and Fed Chair Janet Yellen tend to have nearly identical views. Here are a few highlights of his speech:

(1) In general, he paints a reasonably positive picture of the economy and says, “if my own forecast is realized, I would expect to favor raising the FOMC’s federal funds rate target sometime in 2015.”

(2) He says that several of the “headwinds” restraining US economic activity in recent years have subsided. The housing industry is in better shape. So are consumers. There is much less fiscal drag. Financial conditions are good: “Equity prices are high, borrowing costs are low, cash flows are strong and corporate balance sheets are healthy.”

(3) Lower energy costs should “lead to a significant rise in real income growth for households and should be a strong spur to consumer spending.” He adds that in the aggregate, “the swing from oil producers to consumers is quite large. For example, a $20 per barrel decline in global oil prices results in an income transfer of about $670 billion per year from producers to consumers.”

(4) On the other hand, he doesn’t expect a boom. He doesn’t see much upside from the current levels of housing starts and auto sales. The global economic slowdown and stronger dollar could weigh on US exports.

(5) Despite the drop in oil prices and the strength of the dollar, he expects that the core PCED inflation rate will move back towards the Fed’s target of 2% next year as resource utilization tightens.

(6) He agrees with market expectations that the Fed will start raising the federal funds rate around mid-2015. However, he is also willing to be patient:
Finally, given the still high level of long-term unemployment and the outlook for inflation, there could be a significant benefit to allowing the economy to run "slightly hot" for a while in order to get those that have been unemployed for a long time working again.
(7) The pace of tightening will depend on the response of the financial markets:
If the reaction is relatively large--think of the response of financial market conditions during the so-called "taper tantrum" during the spring and summer of 2013--then this would likely prompt a slower and more cautious approach. In contrast, if the reaction were relatively small or even in the wrong direction, with financial market conditions easing--think of the response of long-term bond yields and the equity market as the asset purchase program was gradually phased out over the past year--then this would imply a more aggressive approach.
(8) Though all this implies that Fed policy is market dependent, Dudley then denied that the markets’ reactions matter:
Let me be clear, there is no Fed equity market put. To put it another way, we do not care about the level of equity prices, or bond yields or credit spreads per se. Instead, we focus on how financial market conditions influence the transmission of monetary policy to the real economy. At times, a large decline in equity prices will not be problematic for achieving our goals. For example, economic conditions may warrant a tightening of financial market conditions. If this happens mainly via the channel of equity price weakness--that is not a problem, as it does not conflict with our objectives.
Sorry, he lost me there.
(Based on an excerpt from YRI Morning Briefing)

Monday, December 1, 2014

Central Banks: Immaculate Intervention
The dramatic rebound in stocks around the world since October 15 once again demonstrates the overwhelming influence of the central banks on global equity markets. The Greenspan and Bernanke Puts have morphed into the puts of the major central bankers. As a result, they’ve made shorting stocks a losing proposition. Underweighting stocks simply because they are overvalued based on historical metrics also has been problematic for conservatively inclined institutional investors, who must at least match if not beat their benchmarks. Consider the following recent chronology of central bank interventions that have boosted stock prices:

(1) Bullard bounce. On Thursday, October 15, the dramatic rebound in stock prices from their lows was triggered by a comment by FRB-St. Louis President James Bullard that the Federal Reserve should consider extending its bond-buying program, currently at $15 billion per month, beyond October due to the market selloff--allowing more time to see how the US economic outlook evolves. Yet in his interview with Bloomberg News, Bullard also said he still believes that the FOMC should start raising the federal funds rate in March of next year.

Then after the FOMC meeting in late October, Bullard praised the Fed’s decision to end the bond purchases. He reiterated that he favors starting to raise interest rates next spring, ahead of the mid-year consensus among his FOMC colleagues. In an interview summarized in the 11/20 WSJ:
Bullard attributed some of the confusion to the fact that many market participants didn’t listen closely enough to what he said. He allowed that monetary policy making has become far more complex and thus more challenging to communicate. But he underscored an underlying consistency to his view, noting what he said about the Fed’s bond-buying program hadn’t altered his long-running view that short-term interest rates should be lifted off their current near zero levels next spring.
(2) Kuroda shock. On Friday, October 31, in a surprise move, the Bank of Japan (BOJ) stated that it is upping the ante on the QQE monetary stimulus program that was announced on April 4, 2013. The BOJ’s press release raised JGB purchases to an annual pace of 80 trillion yen from 50 trillion yen. The pace of buying was tripled for both ETFs (3 trillion yen) and J-REITs (90 billion yen). At the current exchange rate, ETF purchases would amount to about $27 billion. That’s not that much given that the market capitalization of the Japan MSCI is $2.7 trillion currently. So what’s all the excitement about?

The latest program is open-ended, according to the latest press release: “The Bank will continue with the QQE, aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner.” The time horizon for achieving this goal was about two years in the 2013 press release.

On Friday, November 21, Japan’s finance minister told a news conference that the speed of the yen’s recent decline was “too fast.” He added, “There is no doubt about that.” Last Tuesday, November 25, the minutes of the October 31 meeting of the BOJ's governing board showed that the hurdle to further quantitative easing is high. Some board members were concerned that expanding the central bank's quantitative easing could raise the risk that it would be seen as financing the government deficit.

(3) Draghi’s pledge. On 10/11, Bloomberg reported that ECB President Mario Draghi told reporters in Washington that expanding the ECB’s balance sheet is the last monetary tool left to revive inflation, although there is no target for how much it might be increased. He said, “I gave you a kind of ballpark figure, say about the size the balance sheet had at the start of 2012.” That would be a remarkable increase of €1.0 trillion. On 11/21, in a keynote speech in Frankfurt, Draghi said that the ECB will “do what we must to raise inflation and inflation expectations as fast as possible.” In effect, he backed US-style quantitative easing.

Speaking in Finland on 11/27, Draghi said that the Eurozone needs a comprehensive strategy including reforms by governments to get it back on track. His comments and weak CPI data released on Friday lowered the euro to $1.246 and triggered a new set of record-low bond yields for the Eurozone's biggest economies, with France’s 10-year yield dropping below 1% for the first time.

The Eurozone flash CPI estimate rose just 0.3% y/y in November, down from 0.4% in October. Bank loans to nonfinancial corporations fell €132.0 billion (saar) during October, the ninth consecutive monthly decline, and the 26th in 27 months.

(4) Chinese rates. The People's Bank of China cut its benchmark one-year loan interest rate on Friday, November 21, to 5.6% from 6.0% and cut its benchmark one-year deposit rate to 2.75% from 3.00%. The nation's central bank also hiked the upper limit on deposit interest rates to 1.2 times the benchmark rate from 1.1 times the benchmark rate. The bank said that it took the actions, which were largely unexpected and are the first such changes since July 2012, in response to expensive borrowing costs rather than any direct worries about the economy's slowdown. Chinese bank loans rose 13.2% y/y during October, the weakest growth since November 2008.
(Based on an excerpt from YRI Morning Briefing)

Thursday, October 30, 2014

Taking Credit
There were no surprises in yesterday’s FOMC statement, in my opinion. A few Fed watchers thought it was more hawkish than they expected. The statement noted: “Labor market conditions improved somewhat further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources is gradually diminishing.”

That’s not hawkish. It’s a fact and makes sense given that the FOMC wanted to give the QE program lots of credit for the improvement in the labor market now that it has been terminated. That notion was reinforced by the following comment: “The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program.” In other words, Mission accomplished.

I’m sure Fed officials were pleased by the headline for this story on Reuters: “Fed ends bond buying, shows confidence in U.S. recovery.” That’s undoubtedly the message they wanted to send.

The boilerplate “considerable time” clause remained in the latest statement:
The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
So inflation might remain lower than the FOMC expects. Then again, pay no attention to any of this so-called “forward guidance” because it all depends: “However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.”

President Harry S. Truman famously lamented: “Give me a one-handed economist! All my economists say, ‘On the one hand, on the other.’” There certainly are lots of the two-handed variety working at the Fed. In what sense does all this nonsense constitute “forward guidance”?

I was asked yesterday how long before the Fed starts hiking rates might the FOMC drop the “considerable time” phrase. I figure three months. Here is the FOMC’s meeting schedule for next year through the summer, with asterisks marking the meetings with press conferences: January 27-28, March 17-18*, April 28-29, June 16-17*, and July 28-29. Odds are that “considerable time” will be dropped at the March meeting, giving Fed Chair Janet Yellen the opportunity to explain why at her press conference. The first hike might be announced after the June meeting, giving Yellen another opportunity to discuss the committee’s decision.

In this scenario, the question will be whether this would be the beginning of the gradual normalization of monetary policy with small rate hikes in subsequent meetings. It should be, unless the first hike unleashes lots of turmoil in financial markets. That would be the “one and done” alternative scenario.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, October 29, 2014

Considerable Time
The FOMC statement this afternoon isn’t likely to pull any tricks. Given the strength in stock prices so far this week, investors might be expecting some treats. It’s likely that Fed officials were spooked by the violent selloff in stocks earlier this month. So at their pre-Halloween two-day meeting that ends today, they might decide not to surprise the markets one way or the other now that stocks have rebounded. In other words, there might not be any significant changes in the language that appeared in the previous FOMC statement on September 17. If so, then no news should be good news.

For the market, the treat would be if today’s statement still includes the following language from the previous one: “The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

After the release of September’s strong employment report on October 3, the odds of dropping the “considerable time” boilerplate of the past couple of years seemed to have increased, especially since QE was about to end. However, the turmoil in financial markets during the first half of the month might dissuade the committee from deleting it.

In a 10/19 WSJ interview, Boston-FRB President Eric Rosengren said:
So we’ll have to think about exactly what’s the appropriate wording and certainly the financial context that we’re in given the volatility we’ve seen in markets. We’re going to have to weigh how best to avoid further unsettling markets that seem to have unsettled themselves pretty well on their own. So we’ll have to take all those things into consideration. I can’t give you precise language because I think it’s really a committee decision.
In other words, Rosengren and many of his colleagues on the FOMC aren’t just “data dependent.” They are also “market dependent.” Of course, there’s a long tradition for this at the Fed starting with the Greenspan Put and followed by the Bernanke Put. I’ve noted that Fed Chair Janet Yellen has been the “Fairy Godmother” of the bull market since she first joined the Fed as a governor during October 2010. Stocks have usually rallied whenever she has spoken publicly about the economy and monetary policy.

The Fed has been criticized for worsening wealth and income inequality with its NZIRP (near-zero interest-rate policy) and QE policies. Ultra-easy monetary policy has done more to enrich the rich who own stocks than to help the economy. Low interest rates have certainly hurt fixed-income investors.

In his interview, Rosengren, who is in the dovish majority on the FOMC, countered:
The biggest factor that affects inequality is losing your job because if you have no income the income disparity is quite large. So being focused on getting labor markets back to where we think full employment is I think is the most tangible way that monetary policy can impact income inequality.
Then he acknowledged:
That being said, there is no doubt that asset prices are one of the mechanisms on which this is transmitted, so people that own stocks are going to do better than people that didn’t own stocks. But that’s not the only measurement, you need to look at the whole basket. The net effect is substantially weighted towards people that are borrowers not lenders, towards people that are unemployed versus people that are employed. Wealthy people are both employed and tend to lend. The people at the lower end of the distribution tend to borrow. So as a result, I think it’s very consistent with being worried about income inequality.
Fed officials undoubtedly spent some time debating whether to drop “considerable time” from the latest statement. Looking into the past, the fact is that all the major central banks have provided ultra-easy monetary policy for a considerable time ever since the financial crisis of 2008. Looking into the future, they may be forced to continue doing so for a considerable time. That includes the Fed, no matter how the FOMC statement is worded today.

In recent weeks, I’ve written about the possibility of “one and done.” In this scenario, the Fed votes to start raising the federal funds rate in mid-2015. That throws markets into turmoil, causing the FOMC to suspend further rate hikes until further notice. In this scenario, the Fed might get spooked by a true correction in the stock market more severe than this month’s quick dip. The dollar might resume soaring, sending commodity prices into a tail spin. Liquidity might dry up in the capital markets, particularly for high-yield corporate bonds. In other words, the past few weeks might have been just a warm-up act for what’s to come once the Fed starts “lift off.”

One explanation for the latest amazing relief rally in stocks is that investors are increasingly concluding that the Fed is trapped. There’s no way to exit its ultra-easing monetary policy without causing too much turmoil in global financial markets. In this scenario, the federal funds rate remains near zero for a very long time into the future. The 10-year Treasury yield remains below 3% for as far as the eye can see.
(Based on an excerpt from YRI Morning Briefing)

Monday, October 20, 2014

Bully for Bullard!
Over the past couple of weeks, I suggested that the bearish action in stocks might reflect investors’ concern that the central banks have run out of ammo. I corrected that assessment on Thursday, October 16, arguing that they still have bullets, but they may be blanks. The rally late last week suggests that even if they are blanks, investors are happy as long as the central banks keep firing them and make lots of noise.

How else to explain that Thursday’s rebound from the lows was triggered by a comment from FRB-St. Louis President James Bullard that the Federal Reserve should consider extending its bond-buying program, currently at $15 billion per month, beyond October due to the market selloff to see how the US economic outlook evolves. Yet in his interview with Bloomberg News, he also said he still believes that the FOMC should start raising the federal funds rate in March of next year.
(Based on an excerpt from YRI Morning Briefing)

Monday, October 13, 2014

Behind the Curtain
Last Tuesday, FRB-NY President Bill Dudley said that the FOMC is likely to start hiking rates around mid-2015. Last Thursday, Fed Vice Chairman Stanley Fischer agreed with Dudley on the timing of the “lift off” for rates. The latest FOMC minutes released last Wednesday strongly suggested that such forward guidance is meaningless since the Fed’s policy remains data dependent. In addition, the economic indicators that are important to the policy-setting committee can and do change. The minutes suggested that the FOMC is now giving some weight to the pace of foreign economic growth as well as the foreign-exchange value of the dollar.

These new considerations might delay lift off. So why have stocks sold off so hard? If the Fed is stymied from normalizing monetary policy by overseas developments, then our wizards might be trapped without an exit strategy. At the same time, there certainly isn’t much the Fed can do to stimulate global economic growth. In fact, if the Fed delays raising interest rates, then the euro might stop its recent freefall, which Draghi is counting on to revive Eurozone growth and inflation. The same can be said for the yen and Kuroda.
(Based on an excerpt from YRI Morning Briefing)

Thursday, October 9, 2014

Dudley Sees First Rate Hike Coming in Mid-2015
QE will be terminated at the end of this month. In and of itself, this shouldn’t be a problem for the stock market, in my opinion. However, its termination sets the stage for rate hikes by the Fed next year.

FRB-NY President William Dudley spoke on Tuesday. In his prepared remarks, he said, “What I can say with greater certainty is that there still is a significant underutilization of labor market resources.” He is among the leading doves on the FOMC and tends to have the exact same views about monetary policy as Fed Chair Janet Yellen.

This implies that the FOMC will be in no rush to raise interest rates next year, and will do so very gradually. Nevertheless, Dudley added, “The [FOMC’s] consensus view is that lift-off will take place around the middle of next year. That seems like a reasonable view to me. But, again, it is just a forecast.” Dudley did mention the stronger dollar, but toned down his concern about it, which he had expressed at a 9/24 Bloomberg conference. For now, he sees it as “limiting the upside risk” of better-than-expected economic growth and higher-than-expected inflation.

Dudley mentioned that inflationary expectations remain “well anchored” despite the recent drop in the yield spread between the 10-year Treasury and comparable TIPS recently. He did not say, as he had at the 9/24 conference, that the strong dollar might push the core PCED inflation further below the Fed’s 2% target as import price inflation diminished.
(Based on an excerpt from YRI Morning Briefing)

Tuesday, October 7, 2014

Anchor Aweigh
There’s a close inverse correlation between the expected inflation rate--as measured by the yield spread between the 10-year Treasury and the comparable TIPS--and the trade-weighted dollar Since the start of the year, expected inflation has been hovering in a range between 2.12% and 2.31%. It dropped significantly in recent weeks to 1.93% yesterday, coinciding with a sharp increase in the dollar. The TIPS yield has edged down recently, but isn’t down as much as expected inflation. In other words, most of the recent decline in the bond yield was attributable to falling inflationary expectations, which may be related to the stronger dollar.

Fed officials keep close watch on inflationary expectations in the TIPS market. Each of the 11 FOMC statements from December 12, 2012 through June 18, 2014 included the following boilerplate language: “longer-term inflation expectations continue to be well anchored.” That assessment is primarily based on the TIPS yield spread.

The TIPS spread suggests that inflationary expectations are no longer well anchored; instead, they are falling sharply. All the more reason to hold off on hiking the federal funds rate.

The question is why is the spread narrowing sharply? Here’s the rub: It may be narrowing because foreign investors are piling into the US bond market, which is why the dollar is strong. Of course, the strong dollar encourages foreigners to pile in some more since that increases their return in their local currencies. The reason they are doing so is because US bond yields well exceed foreign bond yields, especially in Japan and the Eurozone.

But US bond yields have exceeded foreign bond yields in Japan and the Eurozone all year. What’s changed? The drop in those overseas yields relative to US yields has been especially dramatic this year. Foreign investors have become increasingly convinced that the weak performances of the economies of Japan and the Eurozone will force the BOJ and ECB to maintain their ultra-easy monetary policies and provide additional easing measures if necessary.

In other words, the narrowing of the TIPS spread may have nothing to do with inflationary expectations in the US. Rather, the spread is narrowing because foreign investors are reaching for yield in the US. In Japan and the Eurozone, the central banks are seeking to avert deflation. Their efforts to do so are depressing their currencies and narrowing the TIPS spread in the US.

Fed officials might fret that inflationary expectations are declining, and hold off on raising the federal funds rate. That might actually push bond yields in the US still lower, exacerbating the decline in the TIPS market’s presumed measure of inflationary expectation.
(Based on an excerpt from YRI Morning Briefing)

Monday, October 6, 2014

One and Done?
Friday’s employment report was so good that the Fed’s doves should be hard pressed to put a bad spin on it. They’ve been doing just that to previous employment reports especially since Janet Yellen became the Fed chair on February 3 this year. She’s consistently focused on the weakest numbers in the monthly employment reports. The Fed’s doves want to hold off on raising rates for as long as possible. However, they’ve also said that monetary policy is data dependent.

With the unemployment rate down to 5.9% during September (the lowest since July 2008), the FOMC will be under lots of pressure to start raising the federal funds rate sooner rather than later in 2015. Here’s next year’s FOMC meeting schedule: January 27-28, March 17-18*, April 28-29, June 16-17*, July 28-29, September 16-17*, October 27-28, and December 15-16*. The ones with an asterisk will be followed by a press conference, which will give Yellen the opportunity to explain why the Fed decided to finally start raising interest rates. Given the strength in the labor market, I pick March 18 as D-Day.

Let’s recall what Fed Chair Ben Bernanke said last year at his June 19 press conference:
And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7.0 percent, with solid economic growth supporting further job gains, a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program.
Well, here we are with QE scheduled to be terminated by the end of this month and the jobless rate under 6.0%. Regarding when the Fed will raise interest rates after QE is terminated, Bernanke said, “As I mentioned, the current level of the federal funds rate target is likely to remain appropriate for a considerable period after asset purchases are concluded.”

The phrase “considerable time” has been part of the boilerplate of the FOMC statements (in this post-QE context) since the December 12, 2012 statement, when the FOMC voted to morph QE3 (Fed buys $40bn/month in mortgage securities to infinity and beyond) was morphed into QE4 (Fed also buys $45bn/month in Treasuries) until the unemployment rate falls to 6.5%. It did so in April, falling from 6.7% to 6.3%. The strength of the latest employment report suggests that “considerable time” should be dropped from the next FOMC statement on October 29, especially since QE will be terminated by then. (See our searchable archive of FOMC statements.)

Of course, doves will always be doves. Consider the following:

(1) Yellen has a dashboard. Yellen can still find some weak labor market indicators on her “dashboard.” Most importantly, wage inflation remained at 2.0% y/y, well below her target of 3.0%-4.0%. The labor force participation rate fell to 62.7% during September, the lowest since February 1978. On the other hand, the short-term unemployment rate remains very low at 4.0%, while the long-term rate is down to only 1.9%, the lowest since February 2009.

(2) Evans advocates patience. Last Monday, FRB-Chicago President Charles Evans, who flies with the FOMC’s doves, told CNBC that he believes it would be "quite some time" before it's appropriate to start tightening. Evans sees June as a possibility for the first rate increase.

(3) Dudley is watching the dollar.On 9/24, Bloomberg’s Simon Kennedy reported that FRB-NY President William Dudley is the first Fed official starting to freak out about the strong dollar:

The risk is that Evans and Dudley are both correct. If the dollar continues to strengthen on expectations of a Fed rate hike, it could go to the moon on the first actual hike and threaten to slam the brakes on the economy just as the Fed is finally convinced that it has achieved escape velocity. If so, then that could be “one and done” for rate hikes.

Conceivably, it could also be “none and done.” When the FOMC finally votes to implement its exit strategy from ultra-easy monetary policy, they might find that the door is locked and no one has the key. In this scenario, stock prices could very well melt up.

I’m just thinking outside the box here. Other than last year’s taper tantrum in the financial markets, the Fed has succeeded in exiting QE. The Fed might succeed in normalizing monetary policy starting next year by raising the federal funds rate in a gradual fashion. What’s changed recently for the FOMC, and could complicate the committee’s exit strategy, is the strength in the dollar, which bears watching.
(Based on an excerpt from YRI Morning Briefing)

Thursday, October 2, 2014

Fed Rate Hikes Coming
As I noted in my 9/30 Fed Blog post, FRB-Chicago President Charles Evans told CNBC on Monday that he believes it would be "quite some time" before it's appropriate to start tightening. Evans sees June as a possibility for the first rate increase, but said on CNBC’s Squawk Box that if it were his decision, he'd wait even longer. “If you look at the risks, we ought to balance those and be concerned that sometimes coming out of zero [rates] ... is really a difficult proposition for the economies. And so I'd like to be patient.”

I predicted that there might be more tightening tantrums ahead if investors share Evans’ concerns that the economy might go wobbly on the first rate hike. Most economists believe that once the Fed starts raising rates, that will be a sure sign that the economy has finally achieved the long hoped-for “escape velocity,” which should be bullish for stocks.

Why might a small initial increase in the federal funds rate turn into a serious problem for the economy and the stock market? For starters, it could send the dollar to the moon. That would depress the dollar value of corporate profits earned abroad. It would also depress exports and boost imports.

A more disturbing scenario would be a collapse of the corporate bond market. Investors have been piling into the market as they’ve been reaching for yield. Corporations have responded by issuing bonds at a record pace. Data compiled by the Fed show that nonfinancial corporations (NFCs) raised a record $741 billion in the bond market over the past 12 months through July. A significant portion of those funds were used to refinance outstanding debt at lower yields. The Fed’s Flow of Funds data show that net issuance by NFCs totaled $287 billion over the past four quarters through Q2.

On Tuesday, the WSJposted an article titled, “Corporate Bond Sales Coming at Blockbuster Pace.” Here’s the main finding:
Bond sales from highly rated companies in the U.S. clocked a record pace through the third quarter, as companies took advantage of low rates and investors sought out securities that pay more interest than low-yielding government bonds.

Highly rated firms sold about $913 billion of bonds in the U.S. in the first nine months of 2014, up from $869 billion last year, according to Dealogic's figures, which go back to 1995. That puts the investment-grade U.S. market on pace to beat last year's record issuance of about $1.1 trillion, according to Dealogic.
On Monday, the WSJ posted a similar article about the European bond market titled, “Europe’s Corporate Borrowing Set to Hit Pre-Crisis Peak.” Emerging market borrowers have also been raising plenty of money in the global bond markets.

Lots of those bonds have been purchased by retail and institutional investors, some of whom might try to sell them when the Fed starts actually raising interest rates. The problem is that the corporate bond market tends to be illiquid on a good day. This could be a nightmare scenario for bond funds if they are faced with lots of redemption orders with few buyers for their bond holdings. During July, there was a record $3.6 trillion in bond funds and ETFs.

Blackrock, the world’s largest money manager, is concerned. That’s according to a 9/22 Bloomberg story titled, “BlackRock Urges Changes in ‘Broken’ Corporate Bond Market.” Here’s the main point:
Banks have retained their stranglehold on corporate debt trading despite years of effort by BlackRock and other large investors to eliminate their oligopoly. The top 10 dealers control more than 90 percent of trading, according to a Sept. 15 report from research firm Greenwich Associates. To BlackRock, the dangers of price gaps and scant liquidity have been masked in a benign, low interest-rate environment, and need to be addressed before market stress returns.
If a minor initial Fed rate hike does destabilize global bond markets, then there probably won’t be a second rate hike. That would seriously damage the credibility of the Fed, where the official party line has been that exiting ultra-easy monetary policy won’t be a problem.
(Based on an excerpt from YRI Morning Briefing)

Tuesday, September 30, 2014

Life After QE
Will there be life after QE? The Fed is scheduled to terminate this program at the end of October. There’s no doubt that investors are starting to fret about what comes after QE. They realize that once QE is terminated, all the focus will be on when the Fed will start raising interest rates. So recent comments on this subject by members of the “Federal Open Mouth Committee” seem to be having more impact on daily trading, contributing to the market’s volatility. Consider the following:

(1) Richard Fisher is a retiring hawk. Last Thursday’s 1.6% drop in the S&P 500 was widely attributed to FRB-Dallas President Richard Fisher's warning that interest rates may rise “sooner rather than later.” Of course, he is widely known as a hawk. In fact, he dissented at the last meeting of the FOMC according to the official statement: “President Fisher believed that the continued strengthening of the real economy, improved outlook for labor utilization and for general price stability, and continued signs of financial market excess, will likely warrant an earlier reduction in monetary accommodation than is suggested by the Committee's stated forward guidance.”

Fisher said the Fed might start raising rates around the spring of 2015. He won’t be a voting member of the FOMC next year. Actually, he recently announced that he plans to retire next year. In the past, his comments have never had much if any impact on the markets since the Fed’s hawks have been consistently outnumbered by the doves.

(2) Charles Evans is an influential dove. On the other hand, FRB-Chicago President Charles Evans yesterday told CNBC that he believes it would be "quite some time" before it's appropriate to start tightening. Evans is one of the Fed's dovish regional chiefs. While not a voting member on the central bank's policymaking committee this year, he's a 2014 alternate and will be voting next year. He has been an influential dove, convincing the FOMC to tie policy to the unemployment rate in late 2012.

Evans sees June as a possibility for the first rate increase, but said on CNBC’s Squawk Box that if it were his decision, he'd wait even longer. “If you look at the risks, we ought to balance those and be concerned that sometimes coming out of zero [rates] ... is really a difficult proposition for the economies. And so I'd like to be patient.”

(3) James Bullard is a bellwether. Last Tuesday, FRB-SL President James Bullard said that, at the next meeting of the FOMC on October 28-29 (after QE has been terminated), the Fed may need to drop its “considerable time” pledge for when interest rates will rise. He said, “I would like to get the committee to move to something that is more data dependent.” Bullard won’t have a vote on policy until 2016. Nevertheless, an article in Bloomberg recently described him “as a bellwether because his views have sometimes foreshadowed policy changes.”

(4) William Dudley is watching the dollar. Last Wednesday, Bloomberg’s Simon Kennedy reported:
As Federal Reserve Bank of New York president, [William] Dudley is the only regional Fed chief with a permanent vote on policy and is the central bank’s eyes and ears on Wall Street. So when Dudley says something new it’s worth tuning in. And this week he became the first Fed official to comment on the U.S. dollar since the Bloomberg Dollar Spot Index touched its highest level on a closing basis since June 2010.

“If the dollar were to strengthen a lot, it would have consequences for growth," the 61-year-old Dudley, a former Goldman Sachs Group Inc. economist, said at the Bloomberg Markets Most Influential Summit in New York. "We would have poorer trade performance, less exports, more imports,” he said. "And if the dollar were to appreciate a lot, it would tend to dampen inflation. So it would make it harder to achieve our two objectives. So obviously we would take that into account."
The JP Morgan trade-weighted dollar jumped 1% last week to the highest reading since June 7, 2010.

5) “Tightening tantrums” ahead. All this means that we can look forward to spending October wondering (as we did before the September 16-17 meeting of the FOMC) whether “considerable time” will be dropped from the next statement. It probably will be deleted from the Fed’s boilerplate message. In any event, we can expect more “tightening tantrums” ahead. The stock market may be just as freaked out as Evans is by the notion that the economy might go wobbly on the first rate hike.
(Based on an excerpt from YRI Morning Briefing)

Monday, September 22, 2014

Yellen's Spin
Fed Chair Janet Yellen still knows how to sprinkle the fairy dust on the stock market. I’ve noted in the past that ever since she joined the Fed, stock prices usually have moved higher whenever the “Fairy Godmother of the Bull Market” has spoken publicly about monetary policy and the economy.

She first served at the Fed as vice chair of the Board of Governors, taking office in October 2010, when she simultaneously began a 14-year term as a member of the Board that will expire January 31, 2024. Since becoming the Fed chair on February 3, 2014, for a four-year term ending February 3, 2018, her power to charge up the bull has clearly increased. She did it again last week when she spoke at her third press conference as Fed chair after the latest meeting of the FOMC on Wednesday, September 17. The S&P 500 rose 0.6% from the closing price on Tuesday to Thursday’s closing price, hitting yet another new record high of 2011.23.

In my 9/18 Fed Blog post, I discussed Yellen’s “Theory of Relativity.” Here are some additional related points:

(1) The beat goes on. By my count, Yellen has spoken publicly about monetary policy and the economy eight times since assuming the top job at the Fed. The market has rallied every time with one exception, on March 19 when she said at her first press conference that “considerable time” meant about six months. In other words, six months after the projected termination of QE by the end of October, the Fed would start hiking the federal funds rate. That would be April 2015.

(2) Time isn’t measured with a clock. She subsequently backed away from such specific forward guidance. Indeed, during her press conference last week, she reiterated that Fed policy is data dependent, not date dependent: “I know ‘considerable time’ sounds like it's a calendar concept, but it is highly conditional and it's linked to the Committee's assessment of the economy.” As noted in last week’s FOMC statement, as long as the committee judges that “a range of labor market indicators suggests that there remains significant underutilization of labor resources” and that inflation is running below 2.0%-2.5%, Yellen and most of her colleagues are in no rush to raise interest rates.

(3) The “dot plot” is also meaningless. What about the “dot plot” showing the federal funds rate forecasts of all the participants of the FOMC whether they are voting members of the committee or not? The latest one was released along with the FOMC statement last Wednesday. It shows an upward drift from the previous plot released on June 18.

However, as Yellen said at her previous press conferences, the dot plot is as meaningless as “considerable time.” She reiterated that Fed policy is data dependent, suggesting that the forecasts are just a game they play on the FOMC. At her latest press conference, Yellen said over and over again that there is a lot of uncertainty about the Fed’s forecasts, even over the next few quarters, so just ignore the FOMC’s median forecast for where the fed funds rate will be at the end of 2017.

She first minimized the importance of the dot plot at her first press conference as Fed chair on March 19: “But, more generally, I think that one should not look to the dot plot, so to speak, as the primary way in which the Committee wants to or is speaking about policy to the public at large.” She did it again at her second press conference on June 18: “And around each of those dots, I think every participant who’s filling out that questionnaire has a considerable band of uncertainty around their own individual forecast.”

(4) Back to “measured” pace of rate hikes? The FOMC raised the federal funds rate by 25bps at every meeting during the “measured” pace of tightening under Fed Chair Alan Greenspan from May 4, 2004 through December 13, 2006. Last Wednesday, the WSJ MarketWatch posted an interesting analysis of the latest dot plot, showing that it implied rate hikes at every meeting once the Fed starts raising rates again.
(Based on an excerpt from YRI Morning Briefing)

Thursday, September 18, 2014

Yellen's Theory of Relativity
The Fed is in no rush to raise interest rates sooner than Fed watchers expect. Most of them expect the Fed to start doing so next year either in the spring or early summer. So yesterday’s statement retained the “considerable time” language that has been in the FOMC statements since the September 12-13, 2012 meeting of the committee. Back then, the specific sentence stated:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.
This sentence was tweaked in the December 12, 2012 statement as follows:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends.
That program will end at the next meeting on October 28-29. Most Fed watchers seem to believe that six to nine months is a considerable time, which would mean that the first rate hike should be during either April, May, June, or July of next year.

As widely expected, during her press conference, Fed Chair Janet Yellen reiterated that there is room for improvement in the labor market. She noted that while inflation has risen in recent months, it remains below the Fed’s target. Fed policy remains data dependent, which means that the normalization of monetary policy will depend on the performance of the economy. So once the Fed starts raising interest rates, it could happen at a slow pace or at a fast pace.

On balance, there were no surprises yesterday other than for those of us who thought there was a chance that “considerable time” would be dropped. Clearly, Yellen is solidly in charge of FOMC policymaking, and she is among the most dovish members of the committee. In any event, during the Q&A session of the press conference, Yellen said that “considerable time” has nothing to do with time. She stressed that Fed policy is data dependent. So the Fed will hike rates when the data say it’s time to do so, not when the clock says so. In other words, “considerable time” is basically meaningless. Got that?

The Fed will maintain ultra-easy monetary policy as long as the economy needs it, which will depend on the FOMC’s assessment of the incoming data.
(Based on an excerpt from YRI Morning Briefing)

Thursday, August 21, 2014

Jackson Hole
Central bankers like to get together on a regular basis at nice locales. They do so every year in late August at Jackson Hole, Wyoming. This annual conference brings together the top honchos of the major central banks. They tend to focus their discussions on the hot issues of the day. This year’s topic is “Re-Evaluating Labor Market Dynamics.” The program for the August 21-23 meeting will be posted today at 6 p.m., MT. Last year’s topic was “Global Dimensions of Unconventional Monetary Policy.”

On Wednesday, Bloomberg’s Simon Kennedy reported:
Every time then-Federal Reserve Chairman Ben S. Bernanke spoke at the annual monetary policy symposium in the shadow of Wyoming’s Teton mountains since 2007, stocks rallied. With Janet Yellen set to make her first speech to the conference as central bank chief on Aug. 22, investors may be setting themselves up for a fall, according to Steven Englander, global head of G-10 foreign exchange strategy at Citigroup Inc.
Kennedy noted that from 2007 to 2012, Fed Chair Ben Bernanke’s keynote speech was bullish, with the S&P 500 up an average 1.3% that day. Bernanke skipped last year’s meeting. Englander was quoted as saying that Fed Chair Janet Yellen’s speech could be a letdown: “We worry that dovishness is increasingly anticipated and that by the time we get to her talk anything less than ‘full dovishness’ will be a disappointment.”

I’m not worried. As I noted yesterday, I expect that the “Fairy Godmother of the Bull Market” won’t let us down. In a June 30, 2009 speech, Yellen said that the lesson of history, particularly of the Great Depression, is that premature monetary tightening can be disastrous. I’m sure she still thinks so, and might very well say so again on Friday.

Yellen is a Yale PhD macroeconomist with particular interest in the labor market. She is also a liberal and believes that the labor market needs all the help it can get from the Fed. I doubt that she picked the topic for discussion at Jackson Hole, but I’m sure the folks at the Kansas City Fed, which has been hosting the conference since 1978, did so to please the boss.

Yellen’s liberal bias was plain to see in the statement issued after the July 30 meeting of the FOMC. It noted: “Labor market conditions improved, with the unemployment rate declining further. However, a range of labor market indicators suggests that there remains significant underutilization of labor resources.” The previous statement following the June 18 meeting noted: “Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated.” This change in wording clearly reflects Yellen’s focus on the negatives rather than the positives in the labor markets.

I believe that American consumers are in better shape than Yellen believes. However, if she insists on helping them out with more ultra-easy money than they really need, then stock investors will continue to benefit as well. Again: Thank you, Fairy Godmother!

ECB President Mario Draghi will follow Yellen with the keynote luncheon address on Friday. It’s unlikely that he will drop any new “whatever-it-takes” bombshells, as he did on July 26, 2012. It’s unlikely that he will hint at the possibility of a Fed-style quantitative easing given the legal issues surrounding this program. Instead, he will most likely stress that the ECB’s recent easing moves, including TLTRO lending to the banks starting next month, should help to revive growth in the Eurozone. Unlike Yellen, he is likely to say that monetary policy can’t fix all of our problems, including structural ones in the labor market.
(Based on an excerpt from YRI Morning Briefing)

Tuesday, August 19, 2014

'Fairy Godmother' Will Speak on Friday
Investors may be looking forward to Fed Chair Janet Yellen’s speech at Jackson Hole on Friday. I’ve often affectionately called her the “Fairy Godmother of the Bull Market.” Stock prices tend to rise after she speaks about the economy and monetary policy. That happened often when she was a Fed governor, and has continued now that she is Fed chair.

A few Fed watchers are speculating that the upcoming speech would be a good opportunity for Yellen to signal that she is ready to normalize monetary policy, i.e., hike the federal funds rate. So they are expecting a hawkish speech. I disagree. In a June 30, 2009 speech, Yellen said that the lesson of history, particularly of the Great Depression, is that premature monetary tightening can be disastrous:
If anything, I’m more concerned that we will be tempted to tighten policy too soon, thereby aborting recovery. That’s just what happened in 1936 when, following two years of robust recovery, the Fed tightened policy because it was worried about large quantities of excess reserves in the banking system. The result? In 1937, the economy plunged back into a deep recession. Japan too learned that hard lesson in the 1990s, when both monetary and fiscal policies were tightened in the mistaken belief that the economy was rebounding.

These episodes teach us a valuable lesson that we should heed in the present situation. Let this not be another 1937, but a time when policymakers have the wisdom and patience to nurse the economy back to health. And, when the economy does come back, let it be built on a foundation of sound private investment and sustainable public policies. Only then can we be confident that we can escape destructive boom-and-bust cycles and build a more permanent prosperity. Thank you very much.
Thank you, Fairy Godmother!
(Based on an excerpt from YRI Morning Briefing)

Wednesday, August 13, 2014

Labor Market De-Slacking
Fed Chair Janet Yellen is no slacker. She is a hard worker for sure. You’ll never see a photo of her at the golf course. She would like everyone who wants a job, and wants to work hard, to have the opportunity. She intends to keep interest rates near zero for as long as necessary to do the job. The economy seems to be moving faster toward Yellen’s goal of eliminating slack in the labor market. June’s JOLTS report and July’s NFIB survey of small business owners, which were both released yesterday, certainly confirm this assessment.

Of course, Fed Chair Janet Yellen has said that she won’t be completely satisfied with the progress in the labor market unless wages are rising at a faster pace. That’s not happening so far. During her March 19 press conference, she said:
The final thing I’d mention is wages, and wage growth has really been very low. …. In fact, with the productivity growth we have and 2 percent inflation, one would probably expect to see, on an ongoing basis, something between--perhaps 3 and 4 percent wage inflation would be normal. Wage inflation has been running at 2 percent. So not only is it depressed, signaling weakness in the labor market, but it is certainly not flashing.
Back in July, I suggested that Yellen should read a very interesting 7/21 article posted on Bloomberg titled, “Yellen Wage Gauges Blurred by Boomer-Millennial Shift.” The conclusion is that demographic shifts in the labor markets may keep a lid on wage inflation, which would make it a poor indicator of labor market conditions:
As today’s middle-aged Americans grow older, they are leaving their prime working years behind, trading big salaries for part-time gigs or retirement, just as an even larger group of young people come into the labor force at entry-level salaries. The seismic shift may be one reason behind the sub-par wage growth that Yellen says still shows ‘significant slack’ in the job market.
I concluded then, as I still believe:
If she continues to put too much weight on this demographically flawed indicator, monetary policy may stay too easy for too long (as it has already, in my opinion). What’s wrong with that if wage inflation remains subdued, and so does price inflation? Nothing really, I suppose, unless it all leads to lots more financial bubbles that should have been averted with the more immediate normalization of monetary policy.
(Based on an excerpt from YRI Morning Briefing)

Thursday, July 17, 2014

Yellen: Fashion Statement
Bubbles are in fashion. On Tuesday, when she testified before the Senate Banking Committee, Fed Chair Janet Yellen wore a stylish outfit with a jacket that was grayish looking with lots of white circles. That was a fitting choice since they looked like bubbles, which was a topic covered during her semi-annual congressional testimony on monetary policy. Let’s review the testimony:

(1) Prepared remarks. In her prepared remarks, Yellen said that the FOMC “recognizes that low interest rates may provide incentives for some investors to ‘reach for yield,’ and those actions could increase vulnerabilities in the financial system to adverse events.” She pinpointed the junk bond market, where “valuations appear stretched and issuance has been brisk.” The Fed is also monitoring the leveraged loan market and working on supervising it effectively. On the other hand, she doesn’t see much irrational exuberance in the prices of real estate, equities, and corporate bonds. While they “have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms.”

(2) The report. The Fed’s latest Monetary Policy Report accompanied Yellen’s testimony. The word “stretched” is in fashion. It appeared twice in the report to describe valuations in some asset markets, “particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

The report also downplayed any irrational exuberance in the rest of the equity market: “However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities.”

What about other asset classes? “Beyond equities, risk spreads for corporate bonds have narrowed and yields have reached all-time lows. Issuance of speculative-grade corporate bonds and leveraged loans has been very robust, and underwriting standards have loosened.”

(3) Q&A. During the Q&A session, Senator Tom Coburn (R-OK) framed his question as follows: “Rather than preventing asset bubbles from happening, we're now taking the approach that they're going to happen and we're going to deal with them. It just seems to me now that we're kind of locked in this zero interest rate phenomenon, and one of the consequences of that is reaching for yield, and now we're going to try to attenuate the response to the zero interest rate rather than change the policy so we don't have the bubbles in the first place.”

Yellen responded by expressing confidence in the Fed’s macroprudential tools: “They diminish the odds that bubbles will develop.” However, she did concede, “So I think there are some risks in a low interest rate environment. I've indicated that, and we're aware of them. But I think the improvements we've put in place in terms of regulation both diminishes the odds that risk will develop and, if there is an asset bubble and it bursts, it will--it will, and we're not going to be able to catch every asset bubble or everything that develops.” Her comment raises an interesting question: Might there be too many bubbles to catch?

There was no discussion in either the testimony or the report, nor during the Q&A, of what might happen when the Fed finally starts raising rates. Last year’s “taper tantrum” triggered a mini crisis in emerging market currencies, debt, and stocks. When the Fed starts hiking rates, that could happen again. Another worrisome development under this scenario would be massive withdrawals from corporate bond mutual funds, which have become a large “shadow bank.” That would be particularly troublesome since the corporate bond market has become increasingly illiquid since the Great Financial Crisis.

The biggest bubble of them all, of course, is in government debt around the world. All the more reason why the Fed and other central banks might be very hesitant to raise interest rates. They’ve been getting away with their NZIRPs (near-zero interest rate policies) because CPI inflation rates have remained surprisingly low. That might actually be attributable to ultra-easy money, which has financed too much excess capacity, particularly in China. However, there has certainly been lots of asset inflation (a.k.a. bubbles), and probably more to come.

In her prepared remarks, Yellen was a two-handed economist about the outlook for interest rates. If the labor market continues to improve faster than expected, “then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned.” On the other hand, if economic activity is disappointing, “then the future path of interest rates likely would be more accommodative than currently anticipated.”

During the Q&A, she clearly favored erring on the ultra-easy side of the street. “The Federal Reserve does need to be quite cautious with respect to monetary policy.” She warned about the “false dawns” that tricked Fed officials in recent years. Later, Yellen told lawmakers that “accommodative policy” would be necessary until the economic headwinds that have slowed the recovery are “completely gone.” She didn't explain how she will determine that to be the case.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, July 16, 2014

The Fed: Monetary Policy Report
Yesterday, Fed Chair Janet Yellen presented the Fed’s semi-annual Monetary Policy Report to the Senate Banking Committee. While the accompanying testimonies of Fed chairs always make headlines, the report is rarely even read. Not so the latest one, which provided the following investment advice: “Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms.” In other words, sell them.

That unnerved stock investors despite the following reassurance in the report about the overall market: “However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities.”

Yellen was also reassuringly dovish, stating: “Although the economy continues to improve, the recovery is not yet complete.” Despite all the recent strength in lots of labor market indicators, she claimed that “significant slack remains in labor markets.” She said that this is “corroborated by the continued slow pace of growth in most measures of hourly compensation.” In the past, she indicated that she would like to see wage inflation rise from 2% currently to 3%-4%.

The 7/21 issue of The New Yorker includes a lengthy article about Yellen that’s worth reading. It confirms that she is an impassioned liberal: “Yellen is notable not only for being the first female Fed chair but also for being the most liberal since Marriner Eccles, who held the job during the Roosevelt and Truman Administrations. Ordinarily, the Fed’s role is to engender a sense of calm in the eternally jittery financial markets, not to crusade against urban poverty.”

Yellen is from the Fed, and here “to help American families who are struggling in the aftermath of the Great Recession.” She and her husband, who leans far to the left, have published a series of papers on why labor markets don’t automatically work to maintain full employment. The government can do the job better: "I come from an intellectual tradition where public policy is important, it can make a positive contribution, it’s our social obligation to do this. We can help to make the world a better place.”
(Based on an excerpt from YRI Morning Briefing)

Monday, June 23, 2014

The Fairy Godmother of the Bull Market
The Fairy Godmother of the Bull market did it again last week. Whenever Janet Yellen speaks publicly about monetary policy and the economy, stock prices tend to rise. On Wednesday, the S&P 500 climbed 0.8% to yet another new record high in response to her press conference that day. It rose 0.3% on Thursday and Friday to 1962.87. It would have to gain just 2.6% to reach my yearend target of 2014, which I am thinking about raising. However, a melt-up followed by a meltdown back to 2014 by the end of this year remains a distinct possibility.

Yellen’s pronouncements have tended to be bullish for stocks since she first took office as vice chair of the Board of Governors in October 2010. Now we can look forward to her quarterly press conferences as Fed chair, the position she assumed in February of this year. Of course, Fed policy has been ultra-easy since the start of the bull market, and stocks have also tended to rise after most FOMC meetings.

The stock market’s bulls were charged up last week by both the FOMC’s statement and Yellen’s spin on monetary policy. Consider the following:

(1) Unanimous. The latest statement was almost identical to the previous one on April 30. (See the WSJs Fed Statement Tracker.) Once again, the FOMC reaffirmed its NZIRP, or near-zero interest-rate policy:
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
Remarkably, the vote for the current policy stance was unanimous. No one dissented in favor of language suggesting that interest rates might have to be raised sooner given the ongoing improvement in the economy and the labor markets, as well as the recent rebound in inflation.

(2) Noisy inflation. Even more remarkable, when asked in her press conference about the recent inflation rebound, Yellen blew it off as noise. In her prepared remarks, she didn’t even acknowledge the recent broad-based upturn in inflation:
Inflation has continued to run below the Committee’s 2 percent objective, and the Committee remains mindful that inflation running persistently below its objective could pose risks to economic performance.
Last week, I noted that the core CPI, on an annualized three-month basis, rose from 1.4% during February to 1.8% during March to 2.2% during April to 2.8% during May. I expected some mention of this new inflation risk in the FOMC statement and Yellen’s press conference. Instead, it was like it never happened.

Indeed, Yellen’s response to the first question by CNBC’s Steve Liesman about the possibility that inflation might be on the verge of exceeding the FOMC’s 2016 target was bizarre:
So, I think recent readings on, for example, the CPI index have been a bit on the high side, but I think it's--the data that we're seeing is noisy. I think it's important to remember that broadly speaking, inflation is evolving in line with the committee's expectations. The committee has expected a gradual return in inflation toward its 2 percent objective. And I think the recent evidence we have seen, abstracting from the noise, suggests that we are moving back gradually over time toward our 2 percent objective and I see things roughly in line with where we expected inflation to be.
(3) Unemployment spin. In her prepared remarks, Yellen acknowledged that the labor market is improving, but accentuated the negatives rather than the positives:
The unemployment rate, at 6.3 percent, is four-tenths lower than at the time of our March meeting, and the broader U-6 measure--which includes marginally attached workers and those working part time but preferring full-time work--has fallen by a similar amount. Even given these declines, however, unemployment remains elevated, and a broader assessment of indicators suggests that underutilization in the labor market remains significant.
During the Q&A, Yellen added:
That said, many of my colleagues and I would see a portion of the decline in the unemployment rate as perhaps not representing a diminution of slack in the labor market. We have seen labor force participation rate decline.
She also noted that wage inflation is running around 2%, which is too low in her opinion. It’s barely keeping up with inflation and should be rising faster to reflect productivity. She is rooting for this to happen, and isn’t inclined to tighten monetary policy if and when it does.

(4) No thresholds. The Fed’s experiment with tying monetary policy to a specific threshold for two key indicators started at the December 11-12, 2012 meeting of the FOMC, when an unemployment rate of 6.5% was specified as the “threshold” for discussing raising interest rates as long as the inflation rate wasn’t still below 2%. The unemployment threshold was dropped at the March 18-19, 2014 meeting, the first one with Yellen as chair.

At her latest press conference, Yellen said that the FOMC has reverted to a fuzzier data-dependent approach:
In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This broad assessment will not hinge on any one or two indicators, but will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.
(5) No bubbles yet. Yellen said she sees some signs of speculative excesses, and she is monitoring the low pace of volatility in financial markets, a sign of complacency. However, so far, she doesn’t see a need for monetary policy to respond to these developments, thereby contributing to the markets’ complacency!

Here is what she had to say about volatility:
The FOMC has no target for what the right level of volatility should be. But to the extent that low levels of volatility may induce risk-taking behavior that for example entails excessive buildup in leverage or maturity extension, things that can pose risks to financial stability later on, that is a concern to me and to the committee.
More specifically, she believes that the level of risk-taking remains “moderate”:
Trends in leverage lending in the underwriting standards there, diminished risk spreads in lower-grade corporate bonds, high-yield bonds have certainly caught our attention. There is some evidence of reach for yield behavior. That's one of the reasons I mentioned that this environment of low volatility is very much on my radar screen and would be a concern to me if it prompted an increase in leverage or other kinds of risk-taking behavior that could unwind in a sharp way and provoke a sharp, for example, jump in interest rates. …But broadly speaking, if the question is: To what extent is monetary policy at this time being driven by financial stability concerns? I would say that--well, I would never take off the table that monetary policy should--could in some circumstances respond. I don't see them shaping monetary policy in an important way right now. I don't see a broad-based increase in leverage, rapid increase in credit growth or maturity transformation, the kinds of broad trends that would suggest to me that the level of financial stability risks has risen above a moderate level.
(6) Complacent valuations. With regards to stock market valuations, she remains relatively complacent:
So I don't have a sense--the committee doesn't try to gauge what is the right level of equity prices. But we do certainly monitor a number of different metrics that give us a feeling for where valuations are relative to things like earnings or dividends, and look at where these metrics stand in comparison with previous history to get a sense of whether or not we're moving to valuation levels that are outside of historical norms, and I still don't see that. I still don't see that for equity prices broadly.
(7) Uber dove. Fed policy remains data dependent. However, Yellen is likely to describe the data as “noisy,” and therefore irrelevant if the numbers don’t support her ultra-liberal assessment of the disappointing performance of the economy and her preference for maintaining ultra-easy monetary policy until all ex-cons are gainfully employed. I wish I was kidding.

In her 3/31 speech in Chicago, she briefly described the struggle of three workers in the Windy City--Dorine Poole, Jermaine Brownlee, and Vicki Lira--in the labor market. On April Fools’ Day, Jon Hilsenrath reported in the WSJ:
One person cited as an example of the hurdles faced by the long-term unemployed had a two-decade-old theft conviction. Another mentioned as an example of someone whose wages have dropped since the recession had a past drug conviction.
Hilsenrath also noted that a Fed spokeswoman said Yellen knew of the people's criminal backgrounds and that they were “very forthright” about it in conversations with the chairwoman before the speech!

During last week’s Q&A, Yellen confirmed that she remains one of the FOMC’s most dovish members when she said, “inflation continues to run well below our objective, and we're still some ways away from maximum employment and for the moment, I don't see any tradeoff whatsoever in achieving our two objectives. They both call for the same policy, namely a highly accommodative monetary policy.”

Thank you, Madam Fairy Godmother! Fairy tales can come true, especially for us bulls.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, April 16, 2014

The Fed & Inflation
Janet Yellen, “The Fairy Godmother of the Bull Market,” may soon have to deal with an age-old adage: “Beware of what you wish for, because you just might get it.” She might have to explain why the Fed’s goal is to inflate the inflation rate back to 2%. She obviously wants to avoid deflation. Consider the following:

(1) CPI inflation rate upticking. March data released yesterday showed an increase in the CPI inflation rate to 1.5% y/y from 1.1% the month before. It was led by food prices and rents. The former rose 0.4% m/m, and 1.7% y/y.

(2) Rent inflation rising.The CPI rent of shelter component rose 0.3% m/m, and 2.7% y/y, the highest reading since March 2008. This is a very odd measure indeed. It accounts for 32% of the total CPI. It has two major subcomponents, namely tenant rent and owners’ equivalent rent (OER). The former, which reflects actual rent paid by actual renters and accounts for 7% of the CPI, rose 2.9%, and has been hovering around this rate for the past 10 months. The latter, accounting for 24% of the CPI, has increased from 2.2% six months ago to 2.6% during March.

OER is an imputed measure of the rent homeowners would have to be charged to rent the homes they own. I kid you not, though I’m sure you knew that already. Presumably, it is based on actual tenant rent. Nevertheless, the recent leap in the OER inflation rate obviously can’t be explained by a similar jump in tenant rent inflation.

This oddity is one reason why the Fed prefers to use the personal consumption expenditures deflator (PCED) as a better measure of consumer price inflation. Both rent components are in the PCED too. However, the overall weight of rent of shelter is only 15% of the PCED, with tenant rent at 4% and OER at 11%.

(3) Inflation mandate needs explaining.It’s not obvious to me why the Fed’s commitment to boost inflation is a good thing, especially if inflation is led by higher food prices and rents. We doubt that will stimulate economic activity by causing consumers to buy food and rent apartments before their prices go higher. On the contrary, the rising costs of these essentials reduce the purchasing power of consumers.

Inflation-adjusted average hourly earnings in private industry (using the overall CPI to deflate this measure of wages) fell 0.2% m/m during March. It is still up 0.5% y/y. Tenant rent inflation has been outpacing wage gains since September 2011.

Despite March’s uptick in the CPI inflation rate, we believe that there are powerful deflationary forces offsetting all the monetary stimulus provided by the major central banks of the world. Since the start of 2009, the assets on their balance sheets have increased 78% by $6.2 trillion--at the Fed ($2.3 trillion), ECB ($0.4 trillion), BOE ($0.3 trillion), BOJ ($0.9 trillion), and PBOC ($2.3 trillion).

If anyone had predicted five years ago that this would happen and that the major central banks would be worrying about the possibility of deflation rather than hyperinflation, few would have believed such a ludicrous prediction. Yet here we are, with all the models used by macroeconomists at the central banks to predict inflation clearly not working.

Microeconomic models seem to be more useful in explaining why this is happening. Globalization has made markets more competitive and reduced the pricing power of firms. Technological innovations are inherently deflationary as they boost the productivity of both labor and capital. Instead of "hypering" inflation, ultra-easy monetary policy has funded the development and implementation of deflationary technologies. Easy money has also funded the fiscal excesses of governments that often expanded capacity to provide jobs even if the demand fundamentals didn’t justify such expansion.
(Based on an excerpt from YRI Morning Briefing)
The ECB & Deflation
Over in the Eurozone, ECB President Mario Draghi has been the Fairy Godfather of the bull market, not only in stocks but even more impressively in bonds, especially in the region’s peripheral countries. This past Saturday, at an IMF conference, he sought to reassure investors in these markets that the ECB will do whatever it takes to avert deflation.

Of course, he first made that pledge in the context of defending the euro in a speech on July 26, 2012. Now he is worried that the euro is too strong: “The strengthening of the exchange rate would require further monetary policy accommodation. If you want policy to remain as accommodative as now, a further strengthening of the exchange rate would require further stimulus."

On a year-over-year basis, the euro is up by 8% against the dollar and by 9% against the yen. In recent weeks, it has reached levels against the dollar not seen since late 2011. The strong euro is contributing to deflationary pressures by depressing import prices, which boosts the CPI, and by raising export prices, which could slow the Eurozone’s export engine.

"I have always said that the exchange rate is not a policy target, but it is important for price stability and growth," Draghi said. "What has happened over the last few months is that it has become more and more important for price stability."

On Sunday, at the same IMF conference, ECB executive board member Benoît Cœuré, in prepared remarks, reiterated that the bank’s Governing Council “is unanimous in its commitment to use also unconventional instruments within its mandate,” including asset purchases if additional easing is required to avert deflation.

Some observers claim that this is easier said than done since the ECB's charter forbids it from financing governments. However, buying government bonds in the secondary market isn’t explicitly prohibited. Since assuming the ECB presidency in November 2011, Draghi introduced two major unconventional policies to ease funding pressure in the Eurozone's banking sector:

(1) More than €1 trillion was pumped into the bloc's financial system between December 2011 and February 2012 through the provision of cheap three-year loans to banks. The banks used the funds to buy government bonds. Some observers called it "backdoor Quantitative Easing."

(2) In September 2011, Draghi launched his Outright Monetary Transactions (OMT) program to buy bonds in the secondary market. This ship never left port because of opposition from the Bundesbank. In addition, Germany's constitutional court in a preliminary ruling in February claimed, "there are important reasons to assume [OMT] exceeds the [ECB's] mandate.” However, final judgment was deferred pending a ruling by the European Court of Justice.

In any event, Draghi’s pledge to do whatever it takes to defend the euro worked like magic to ease financial conditions in the Eurozone. It’s not obvious how actually implementing a QE program now will work much better to boost inflation given that government bond yields are already so low. It would have to channel more of the monetary stimulus to the private sector through purchases of asset-backed securities, which are in short supply currently.

A QE program would have to dramatically lower the foreign exchange value of the euro. Over in Japan, the essence of Abenomics over the past year was to use massive monetary easing to depreciate the yen and boost inflation. But the shock-and-awe may be wearing off already. Central bankers may soon have to consider the possibility that they aren’t as powerful as they believe themselves to be against the forces of deflation.
(Based on an excerpt from YRI Morning Briefing)