How to Trade Aftermath of Janet Yellen's Last Big Decision

 | Dec 13, 2017 | 3:41 PM EST
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All the media attention on this Fed meeting will be about Janet Yellen's exit. It will be her final press conference as Chair and that will be an opportunity to reflect on her time at the helm. Real Money is a site about investing ideas, and there isn't anything actionable about reflecting back. Hence I'm going to focus on what this rate hike means and what new information we can glean from the Fed's new economic projections. On Yellen I will just say that while the economy performed very well under her watch, and I would have been fine with another term for her, I can't call her tenure an unmitigated success. She was a poor communicator in that her actions didn't seem to line up with her words. In particular, her insistence that 2% was really the inflation target while simultaneously not actually trying to hit it, diminished the Fed's credibility. She either should have communicated it differently or acted differently.

With that being said, let's look forward to where the Fed goes next. 

The Rate Hike

No surprises here of course. The Fed has been telegraphing this hike for most of the last year, and the market has believed them for at least the last 3-4 months. 

What is notable is that they continue to hike despite scant evidence of accelerating inflation from either wages or goods prices. The Yellen regime seemed to put more weight on falling unemployment and rising asset prices than actual inflation prints. Will Jerome Powell operate any differently?

We can't know until we see Powell in action. However, we do know the Powell Fed will skew more hawkish. The incoming members President Donald Trump has already nominated (Randal Quarles and Marvin Goodfriend) are clearly more hawkish than their outgoing members (Yellen and Stanley Fischer). I would bet that the additional seats Trump fills will also push the Fed in a more hawkish direction. Worth noting that by "hawkish" I don't mean their current preference for policy, which is what most pundits mean when they use the term. I mean more their view on the relative value of low inflation vs. faster growth. All economists believe that the Fed should keep inflation low and stable. But some view the risks of mildly higher inflation as more pronounced than others. A dovish economist might say that inflation at 1.5% is just as problematic as inflation at 2.5%, whereas a hawkish one might think the former is fine while the later is dangerous. 

Readers hopefully see the distinction between calling someone hawkish because they want to hike right now vs. a general perspective on inflation. Goodfriend himself, for example, advocated for negative interest rates when inflation was problematically low. That doesn't make him a dove. I call him a hawk because I'm certain he will advocate continued rate hikes even if inflation doesn't rebound. To the extent that Goodfriend and Quarles have influence over policy, the market is undershooting in its rate expectations. 

The Economic Projections and Dot Plot

This isn't quite as meaningful given the change in leadership at the Fed, but still worth checking out. There wasn't much change in the base economic projections. Full-year 2017 GDP was projected 0.1% higher than September (+2.5 vs. +2.4%), but 2018 was upgraded to 2.5%. The unemployment rate projection was dropped to 4.1% (from 4.3%) which is just an acknowledgment of where we actually are.

Worth noting that the Fed projects that unemployment will fall only slightly next year to 3.9% and then steady through 2019. By implication, they expect the pace of job gains to slow meaningfully. For unemployment to remain steady, employment gains probably need to slow to around 90,000 per month. Also worth noting that a 2-year period of steady unemployment would be totally unprecedented in history. As I've written many times, employment historically has always either grown at a brisk pace or fallen into negative territory. There haven't been any actual instances where job gains were mediocre for an extended period. If the economy keeps growing, unemployment will keep falling. Given the momentum we already have, I expect something like 3.7% or even lower by the end of 2018 unless the economy starts to slow.

Getting back to my point above, as unemployment keeps falling, the Fed will assume that their current interest rate target is still providing stimulus. Or put a little more technically, if unemployment is still falling it is probably true that the current rate is below the neutral rate. So the Fed will want to keep hiking. Here again, I think the market is probably behind the curve, and the risk is very skewed. There is much more room for the Fed to hike more than the market thinks and not much room for it to hike less.

On the dots, the only really interesting thing is that we got a new member (Quarles) voting for the first time. My best guess is that his 2018 dot is 2.5% and 2019 is above 3%. If he's lower it suggests that someone else pushed their dots a good bit higher.

My View

I've tipped my hand already in that I think there is much more risk to the Fed hiking more than the market thinks than the opposite. I've closed out my position in the dollar but will look to get back in at some point. I also think the yield curve keeps flattening with 10-30 year bonds about steady and 2-7 year bonds rising. 

Another good way to play it is through financials. The Financial Select Sector SPDR Fund ETF  (XLF)   has had a very strong correlation with the 5-year Treasury yield which I expect will continue. If I'm right that 5-year yields keeps rising there's much more upside there. 

Most financials should work, although banks and brokers are probably your best bet. The megacap banks don't really have a lot of exposure to the shape of the yield curve, and brokers like Schwab (SCHW) have a lot of upside if money market yields keep rising and they can get some fees off money markets.

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