Yellen at Jackson Hole: Don’t Rock the Boat?

This post previews Janet Yellen’s 26 August Jackson Hole appearance, and the likely market implications.  The main points are:

  • Recent FOMC mixed messages – Dudley’s/Fisher’s recent small hawkish drift versus Williamson’s/Bullard’s dovishness, reflecting the difficult issues confronting the Fed – underpin market confusion about Fed policy.
  • Neverthless, markets remain sceptical about the likelihood of further US rate hikes in 2016:  only a 30% (55%) chance of a September (December) rate hike is priced. The latter risks being revised up over the coming months.
  • While Yellen will likely reiterate her data-dependent risk-management focus, there’s a good chance that she’ll leave the door open to September or, especially, December rate hikes. Markets seem over-complacent that the apparently-academic title of Yellen’s speech will prevent her dropping policy hints.  Specifically: (i) Yellen hasn’t opined on policy since June and US data  have subsequently generally improved (e.g. the labour market); (ii) she may also view market Fed pricing as overly dovish; (iii) there may be greater constraints on policy discussions as the presidential election warms up; (iv) it would be unusual for Yellen to depart significantly from Dudley/Fischer’s views; (v) the recent continued easing of US financial conditions may reduce concerns about dollar strength (although there’s clearly an endogeneity here); (vi) US inflation breakevens show signs of stabilising, albeit at relatively-low levels which could still concern FOMC.
  • That said, I’ve been banging on about the flatness of the US Phillips curve for over a year, some recent US data have disappointed and much of the Jackson Hole discussion seems likely to focus on just how much the neutral rate (r*) has fallen (following Williams’ speech) and other monetary strategy issues.
  • Mildly hawkish Yellen comments will likely provide limited near-term USD support (EURUSD below 1.12, USDJPY above 102) and potentially inhibit the recent risky asset rally.
  • But USD could well struggle for substantial traction over the next few months absent strong Fed signals, and given continued market Fed scepticism (USD has been weaker than implied by rate differentials since early 2016, see Chart).  Indeed, EURUSD could rise back above 1.16 and USDJPY fall towards 0.95 should the ECB and BoJ disappoint remaining dovish expectations in September.
  • The US presidential race has yet to significantly impact the dollar, but represents a potential downside: even if opinion polls/betting markets continue to support a Clinton victory, markets should (hopefully) internalise the lessons of the UK EU referendum (see here).
  • GBPUSD’s recent mini-bounce (short squeeze of very stretched GBP positions, see here) is more vulnerable to further evidence of the adverse macro impacts of the Brexit vote emerging. Recent better than expected labour market and retail sales data aren’t where the main Brexit impacts will be felt. And market have overlooked signs of weakness within them. Achieving 1.20 would require 2-year OIS rates to fall around 30bp.
  • A neutral/dovish Yellen would further support market risk-appetite near-term. But the recent market burnt fingers on FX carry trades (previously the dominant 2016 FX market theme in the relatively-low volatility environment, see Chart) generated by several idiosyncratic factors will likely reduce market interest in such trades.

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Mixed messages from the Fed: market remains sceptical on 2016 rate rises

The market goes into Yellen’s Jackson Hole speech somewhat confused on the direction of Fed policy, albeit with it’s dial firmly set to “sceptical”, as it’s previous triumphs over Fed over-optimism on rate hikes (as they got to the r* issue earlier) interacts with decidedly mixed-messages from the FOMC.

Specifically, the July minutes revealed clear divides between doves and hawks on timing/pace of normalization (although they were broadly less hawkish than some market participants had anticipated given that the July FOMC statement argued that “near-term risks to the economic outlook have diminished“).  Overall, there was a wait and see approach: “…many judged that it was appropriate to wait for additional information that would allow them to evaluate the underlying momentum in economic activity and the labour market…” But the hawks were getting restless: “a few participants…supported taking another step in removing policy accommodation”.  But equally the doves were staking their ground: Several suggested that the Committee would likely have ample time to react if inflation rose more quickly than they currently anticipated, and they preferred to defer another increase in the federal funds rate until they were more confident that inflation was moving closer to 2 percent on a sustained basis.

Of course, the minutes have been somewhat superseded by the relatively-strong July labor market release, with non-farm payrolls averaging 190k over the past three and six months and average hourly earnings rose to 2.6% (see Chart).  So it was revealing that Yellen’s deputy Stanley Fischer described the US labour market as “remarkable resilient” to a series of shocks and opine that the Fed is close to it’s targets.  And that echoes New York Fed Governor Dudley’s views that “we’re edging closer towards the point in time where it will be appropriate I think to raise interest rates further.” and that “the market is complacent about the need for gradually snugging up short-term interest rates over the next year or so.”  It’s worth recalling that Dudley has never dissented on an FOMC decision, so his more hawkish views could presage a wider shift.

While Fischer noted that GDP growth had been “mediocre at best“, he expects it to pick up as the inventory drag fades (see Chart below) and the impact of the dollar appreciation reduces. And the hope is that higher US household formation, as the substantial Millennial generation enter their 30’s, will eventually support residential investment. Plus the record three consecutive quarters of negative non-residential investment seems ripe for a rebound (capital is wearing out!).   The big caveat here is that Fischer is worried about lower US trend growth: driven by both lower capital per worker and historically-weak TFP growth (in turn partly a reflection of recent weak capex).

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Conversely, we’ve had dovish interventions by San Franscico Fed’s John Williams (arguing for potentially raising the inflation target, see here) and St Louis Fed’s James Bullard (advocating that the economy is characterised by distinct regimes which are difficult to forecast the transitions between, see here and here).  Moreover,  Charles Evans recently also argued that he’s prefer to wait for higher inflation and that the Fed should consider engineering inflation overshoot (see here).  But he also acknowledged that a 2016 Fed rate hike could nevertheless be appropriate.

Of course, this dispersion of views reflected the extremely-tricky combination of factors confronting the FOMC.  So it’s unsurprising that financial market participants are confused.  Former Fed Chair Bernanke recently argued that the solution is for market participants to paying more attention to the data and less to FOMC commentary, but that seems to be taking things too far.

Markets appear (overly?) relaxed about Yellen’s speech

Nevertheless, given this intense debate, encompassing considerable uncertainty about how much stimulus the Fed is actually providing (given that r* has likely fallen, but FOMC don’t really  know how much) markets appear suprisingly-relaxed about Yellen’s speech. Specifically, FX, equity and bond market implied volatilities lie at relatively-subdued levels, although they’re been edging up in recent days (see Chart below).  Indeed, short-maturity USD vols lie below 1-month ones (as the latter now encompass the Fed/BoJ/ECB September policy meetings).  And market pricing of future Fed hikes remains dovish, even if it’s edged up in recent days (see Chart above), only a 30% chance of a September rate hike and a 55% chance of a December hike seem a little too dovish to me: they will eventually likely be revised up (especially the December probability) although not necessarily on what Yellen says on Friday.

That apparently relatively-relaxed market attitude seems encouraged by the academic title of Yellen’s speechThe Federal Reserve’s Monetary Policy Toolkit” (within the overall symposium theme “Designing Resilient Monetary Policy Frameworks for the Future“), which doesn’t strongly imply an immediate policy focus. Plus Yellen hasn’t previously used Jackson Hole as a launchpad for substantive policy comments.  Or traders simply might not know how to trade Yellen, given the large imponderables, and so remain side-lined.

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But several factors suggest that Markets could be too relaxed about Yellen’s speech:
(i) Yellen hasn’t opined on policy since June, then reacting to the weak May payrolls data, and the US data have generally improved since then;
(ii) she may also view market pricing of the Fed as very dovish;
(iii) there may be greater constraints on policy discussions as the presidential election warms up (so she’ll need to start commenting soon);
(iv) it would be unusual for her to depart significantly from Dudley/Fischer’s views;
(v) the recent continued easing of US financial conditions (see chart above) may reduce concerns about dollar strength being generated by stronger hints at rate hikes (although there’s clearly an endogeneity here);
(vi) As noted in the July FOMC statement, US inflation breakevens show signs of stabilising (see Chart below), albeit at relatively-low levels which could still concern FOMC despite their traditional scepticism about taking such measures at face value.

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Risk management focus, but leaving door open to September or (especially) December rate hike

But my central expectation is that if Yellen does get into policy hints in her speech, her start-point will continue to be her previously-espoused risk-management approach (i.e. taking account of the greater downside risks of tightening too rapidly, given the proximity of the lower bound). And that would be taken dovishly by the markets, especially if her admiration of the labor market isn’t as strong as Dudley and Fischer. But Yellen will likely also want to maintain maximum policy flexibility  going forward: i.e. avoiding an eventual rate rise coming out of the blue.  And that means she could recognise that US data have generally improved and so hint that September and, especially, December remain live FOMC meetings.  But in such a scenario Yellen will almost inevitably also r-iterate data dependence, that there’s no preset course to rate rises and that the rises will be limited.

To be clear, I’ve long been personally at the more dovish end of the spectrum: reflecting my concerns about flat US Phillips curves (see Chart) and the uncertain r* fall. Moreover, US data have recently disappointed a little, which seem to have some connection with the USD weakness over recent months (see Chart and further discussion below). But the task is obviously to try and call the FOMC’s, and especially Yellen’s thinking, and the likely impact on markets.

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Dollar weaker than implied by rate differentials, will likely struggle unless strong Fed steer  

And overall relatively-neutral Yellen comments would support market risk appetite, supporting global equities, probably encouraging a further bond market rally (lower yields) and weakening USD.  But, as discussed above, the risks seem a little skewed to Yellen being a little more hawkish than the market is anticipating: given that much of the market appears to be not expecting any Yellen policy comments, the risks appear unidirectional.  And such limited Yellen hawkishness would likely provide limited near-term support for the dollar: EURUSD would likely fall back to below 1.12 while USDJPY could rise above 102. The 2 September labour market release will be closely watched by the market, although the US seems close to meeting the full employment part of the Fed’s mandate.

Notably, however, USD has been substantially weaker than implied by US-foreign rate differentials since early 2016. The FX market hasn’t really bought into the prospective policy divergence story, which will represent a barrier to USD appreciation should it persist (although we can’t rule out )

  • The chart below illustrates this for 2-year swap rates: USD TWI should actually have risen slightly had it continued it’s previous relatively-strong link (this is a more amplified story of the 10-year rate differential chart shown in the introducion).
  • Breaking things down into their constituents reveals that the strongest links are between USDJPY’s weakness and sharp declines in 10-year Treasury yields (see Chart), although even here there’s an end-sample gap (which is less apparent for UST-JGB relatie yields).
  • While it’s much harder to uncover the usual expected links between EURUSD and EA-US rate differentials, this could reflect the need to examine real interest rates, given low nominal bond yields and fragile inflation breakevens.

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So absent a strong Fed signal, and given continued market scepticism about the FOMC following up with actual rate rises, USD seems likely to continue to struggle for traction over the coming months. Indeed, EURUSD could rise to above 1.16 and USDJPY fall towards 0.95 should the ECB and BoJ disappoint remaining (reduced) dovish expectations in September.

No Trump impact on USD thus far, but can’t be ruled out as November election approaches 

One dog that doesn’t seem to have barked about USD’s weakness is the US Presidential election race.  The chart below illustrates that there’s actually been a weakly negative correlation between betting market odds of Hilary Clinton winning and DXY (rather than the positive correlation I had expected based upon her proposed policies being more economically-literate). But the possibility of a Trump victory could nevertheless start weighing on USD as November approaches.  Even if opinion polls/betting markets continue to support a Clinton victory, markets should (hopefully) internalise the lessons of the UK EU referendum and realise that such metrics are very imperfect measures of electoral preferences, especially when there is a large number of previously disenchanted and disengaged voters who could conceivably throw the form book out of the window (see here).

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Recent GBPUSD bounce vulnerable

It’s also been notable that, within this overall picture of USD weakness, that GBPUSD has experienced a mini-bounce, with a short squeeze of the very stretched GBP positions I discussed here  contributing).  But this bounce seems vulnerable to further evidence of the adverse macro impacts of the Brexit vote emerging. Indeed, the recent better than expected labour market and retail sales data that have contributed to the bounce aren’t at the epicentre of Brexit impacts.  For households Brexit’s impacts should show up most in purchases of durable goods (cars etc) and hence the broader (national accounts) measure of consumption (which is imperfectly correlated with retail sales) as well as in the housing market (next week’s BoE mortgage approvals/lending data will be interesting). Moreover, the market has overlooked signs of weakness within the retail sales and labour market releases: (i) retail sales volumes have been boosted by sharp price falls – nominal sales are weaker – but GBP’s collapse means that’s going to end, alongside falls in household real incomes; (ii) the slowdown in full-time employment apparent for a few months continued, with higher self-employment potentially representing hidden unemployment.  And, of course, such monthly releases can be erratic – e.g. retail sales being supported by UK sunny weather.

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That said, the CBI industrial trends survey was also stronger than expected, including export orders rising to a 2-year high (see Chart above).  Although not “high” in an absolute sense, export orders appear to have been more responsive to GBP’s fall than during the financial crisis (when export markets were very weak). But it means that next week’s PMI releases will be eagerly-anticipated: as I discussed , one caveat of MPC reacting strongly to the cratering PMIs was that the LLoyds Bank Business Baramometer bounced after it’s initial sharp post-Brexit fall.

Of course, any PMI recovery (or better than expected UK data in general) could well reflect the fact the MPC rode to the rescue by easing aggressively.  And such a policy response can raise further issues: putting pension funds under further pressure, reducing the incomes of those reliant on savings (many of whom may have backed Brexit). Indeed, the BoE’s apparent continued difficulty in sourcing long-dated gilts (see here) reinforces my surprise that they didn’t amend the scheme to address pension fund concerns (see here).

But overall GBPUSD still seems likely to head down over the next few months: the recent bounce to around 1.32 represents a more attractive entry point for short positions. But my end-year target of 1.20 may prove harder yards given the role positioning and the likely delay in evidence accumulating on the damaging macro impacts of the Brexit vote . But it remains notable just how closely correlated GBPUSD is with 2-year OIS rates: further GBPUSD falls requires pricing  of further MPC rat cuts.  And such recent relationships imply that GBPUSD of around 1.20 would require 2-year OIS rates to fall around 30bp to 0.15%. While that may be a bit of a stretch, it’s also possible that risk premia can grow, reinforcing the downward pressure on GBP e.g. should funding the current account deficit become more difficult.

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Recent hit to carry trades, despite low-vol environment, could affect behaviour

GBP’s relatively good recent performance – rising the most versus the USD over the past fortnight (see Chart) – is also part of a tendency, contrary to the expectations of many market participants, for carry trades to perform poorly in recent weeks despite low-volatility environment that’s usually a godsend to them (see here).  That seems to reflect a combination of idiosyncratic factors: (i) ZAR weakness on renewed political uncertainty, which shows some signs of dissipating; (ii) MXN being undermined by S&P ratings downgrade, outweighing the the lower probability of a Trump election victory; (iii) BRL weakness on concerns about intervention to following manufacturing firm competitiveness concerns.

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But it’s nevertheless notable that the uptrend in carry-trade returns apparent since March (see here) has been rudely interrupted. Although the occasional setback is to be expected, the difficultly in calling the major central banks’ policies could mean that the latest burnt fingers could reduce investors’ interest in such strategies.  And given that carry trading seems to have been the main game in town in 2016, if we believe the trends in thematic traded products like those detailed in the Chart above, this could leave the FX market even more directionless.

 

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