Yellen to Market: Can You Hear Me Now?

 | Aug 26, 2016 | 1:30 PM EDT
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This commentary previously appeared on Real Money Pro on Aug. 26, 2016, at 11:43 a.m. ET. Click here to learn about this dynamic market information service for active traders.

Fed Chair Janet Yellen's speech at the Jackson Hole conference today wasn't too shocking in its content, but it has sparked a pretty big market reaction. Here are my thoughts both on the speech and what the market is thinking. 

Case for Rate Hike Is 'Strengthened' 

There isn't a ton to say about this, but it is the only part of the speech that has any immediate impact. She opened by talking about how things are looking better in the economic data, and then opined that "the case for an increase in the federal funds target has strengthened in recent months." 

On Tuesday, I wrote a bit about the "cry wolf" Fed, and thought she would have to say something pretty darn explicit to move the market's expectations materially. Indeed, she did say something pretty darn explicit, and yet odds for a December rate hike (as measured by fed funds futures) only moved up about 3% (to 55%). Interesting that the odds of no hikes between now and March 2017 are basically unchanged. So all that happened is that some percentage odds that were assigned to the next hike being in March were moved up to the next hike being December. But that's about it. Once again, the Fed has so little credibility with its words that it is going to need to actually hike before really getting the market's attention. 

What Will the Next Recession Bring? 

Yellen mentioned two "major additions" to the Fed's tool kit since the last recession: large-scale asset purchases (a.k.a. QE) and "increasingly explicit forward guidance." It is quaint that Yellen still thinks forward guidance is effective given the current state of the Fed's credibility. 

Anyway, the meat of the discussion on the future focused on the problem of stimulating the economy when rates are already low. She acknowledges the key problem: In the past, most recessions began when Fed policy was tight. So they could easily stimulate the economy by simply unwinding their prior tight monetary policy. In this cycle it is extremely likely that rates won't even be at long-run neutral much less "tight" by the time we hit a recession. 

She doesn't say it, but this is actually a meaningful point. By admitting this, Yellen is throwing cold water on the idea that the Fed should hike solely for the purpose of creating room to cut in the future. I always thought that was a dumb idea, but many put it forward as a reason to hike. I'm not sure if she meant to discredit that concept, but it at least shows she isn't thinking that way as she's considering future possibilities. 

Yellen then says a QE program of $2 trillion would have a similar impact of cutting rates by 3%. That's getting a lot of headlines, but the dollar figure isn't terribly meaningful. It is just an illustration based on a very stylized model of the economy. All the number really says is that the Fed is pretty comfortable with QE as a tool and even a very large purchase amount probably doesn't cause the Fed to flinch. 

She also mentions the possibility of more radical ideas, like buying non-governmental bonds or other assets, or even changing the Fed's targeting regime overall. She gives a caveat by saying the Fed isn't considering these options. That makes sense in terms of ideas like nominal GDP targeting, which would take considerable time and research to actually implement. But buying other types of assets is not under consideration only because we aren't in a recession. When we get there, it will definitely be under consideration. 

The only other thing worth considering here is that she doesn't mention negative rates at all. I thought perhaps she would express some skepticism about negative rates as a tool, which she doesn't do explicitly. But certainly she doesn't expect that to be a tool used during the next recession. 

What About the Market's Reaction? 

Putting all this together, it indicates that the basic current rate regime is likely to be the same for quite a while. Short-term rates may rise in September or December, but the slope of rate hikes might be incredibly slow. Moreover, when we do get to another recession, or even a hint that we're headed there, expect a firehouse of QE to be unleashed. 

Long-term bonds like this because it probably means the Fed's target doesn't get much past 1%-1.5% before a recession comes. So arguably at 1.54%, the 10-year Treasury is cheap. Imagine for a moment that we don't even peak at 1.5% over the next two years, then a recession hits and rates get cut to 0% for two years after that, and then only slowly rise again after the recession is over. Under that scenario, there is no way the Fed's target averages 1.5% over the whole 10 years. 

Why are risk assets rallying? I guess because they love QE and are hearing that more is coming? Hard to know. But what it does show is that traders are getting past the obsession with the next rate hike and are focused on where rates are headed over time. And rates aren't headed much of anywhere.

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