The last few weeks have seen the ‘hawkish’ global central banks making a lot of noise…Tom Essaye of the Sevens Report said in a note. Click here to read the full article.
If their comments are more hawkish than expected it will be a…writes Tom Essaye, founder of Sevens Report Research. Click here to read the full article.
“Futures are marginally lower as markets digested the slightly hawkish FOMC minutes,” writes Tom Essaye, founder of Sevens Report Research. Click here to read the full article.
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Markets interpreted Fed Chair Yellen’s comments to theHouse Financial Services Committee (HFSC) on Wednesday as dovish, and stocks rallied. However, I think that interpretation is more based on the markets’ perma-dovish expectation, and not the reality of her actual comments.
Broadly, the market confirmed that opinion, as the dollar was higher following her remarks. And though bond yields and banks did decline, the respective drops weren’t bad, especially considering the recent run up in yields and bank stocks. If Yellen was really dovish I would have expected the 10-year Treasury yield to fall sharply. Instead, it just drifted lower.
As I saw it, Yellen was broadly neutral, and most importantly, didn’t do anything to alter the expectation that the Fed will reduce the balance sheet in September and hike rates in December. To prove that point, I want to review the three lines of text the media focused on to spin Yellen’s testimony as dovish, and note they didn’t really change anything from a policy outlook standpoint.
Line 1: “Roughly equal odds that the U.S. economy’s performance will be somewhat stronger or somewhat less strong than we currently project.” I suppose that is less optimistic than if she said, “I think risks to the economic forecast are skewed higher.” But just because she didn’t say that doesn’t mean it’s a dovish statement.
More to the point, Yellen wouldn’t imply risks are skewed higher because 1) It’s probably not true (data hasn’t been great so far in 2017) and 2) She knows she’d spike yields. Additionally, to focus on that one statement is a bit of cherry picking, as Yellen made multiple positive mentions about the acceleration of economic growth.
Line 2: “Rates Won’t Have to Rise Much Further To Get to Neutral.” First, that’s nothing new. We know the Fed’s “neutral” interest rate level is very low (likely below 3%). Second, she continued by saying the “neutral” rate will rise over time as the economy gets better. So, as the neutral rate rises, so too will interest rates. Again, nothing new, and not dovish on its face.
Line 3: “There is—for example, uncertainty about when—and how much—inflation responds to tightening resource utilization.” First, tightening resource utilization is Fed speak for a tight jobs market. So, “responds to tightening resource utilization” is just the idea that rising wages (which are the result of a tightening labor market) causes broad-based inflation. Translation, Yellen said, “I don’t know when low unemployment will cause inflation, or how high inflation will get.”
Importantly, Yellen admitted we didn’t know “when” or “how much” inflation would rise given low unemployment, but she didn’t imply we don’t know “if.” Point being, her comments imply it will happen, it’s just un-clear when or how big it will be. Again, nothing new… and not dovish.
Bottom Line
Broadly, investors also focused on Yellen’s repeated mention of low inflation, which makes me think Friday’s CPI report could be soft, but to extrapolate out her comments as a dovish shift is too aggressive at this point.
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The simple answer is probably not, but there is a better chance than previous meetings because of one simple reason: Despite two rate hikes since December, in aggregate, “financial conditions” have gotten “looser” in 2017, so Fed rate hikes aren’t really working.
Financial conditions is a term that was coined (for all intents and purposes) after the financial crisis, so we could see financial conditions were getting very tight (i.e. less credit availability) and when liquidity was drying up.
Now, in a post-crisis world, multiple institutions keep “Financial Conditions Indices” that measure the level of interest rates, liquidity in the system, credit availability and other measures of whether the availability of money and credit is getting loose (i.e. more availability) or tight (less availability).
I watch three such indices: (withheld for subscribers—unlock with a free trial). All three have slightly different methodologies, but all generally try and accomplish the same objective, which is to see if financial conditions in the economy are “looser” (i.e. easier credit/more liquidity) or if they’re getting “tighter” (i.e. less credit and less liquidity).
Here’s the important takeaway: All three financial conditions indices have shown aggregate financial conditions getting looser since the start of the year. In fact, in aggregate, financial conditions have eased by the equivalent of a 25 basis point rate cut since 2017 started, despite two rate hikes.
The reasons for this are somewhat obvious: Liquidity remains ample; credit remains readily available, interest rates are down, the stock market and housing prices are up (so more ability to borrow).
From a Fed standpoint, the takeaway is this: The fact that the Fed’s “slow walk” in interest rates isn’t mopping up excess liquidity in the market may make the central bank more prone to get “hawkish,” which again would be positive for banks and cyclicals (i.e. the reflation trade), but negative for defensives and higher-yielding sectors (utilities, consumer staples, REITs).
Again, I’m not saying the Fed will be surprisingly hawkish today, but if I had to bet on a surprise based on these financial conditions indices, I’d bet hawkish over dovish (although I’m making the dangerous assumption the Fed is serious about getting rates back to normal levels).
Bigger picture, though, the takeaway here is that the Fed’s policies, so far, are not having the desired effect. And, if this continues, the Fed will have to “shock” markets with a substantial rate hike at some point if it wants to regain market related credibility—and that increases the risk of higher rates over the longer term (or, higher inflation if they don’t provide that shock).
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