Via Scotiabank's Guy Haselmann,
Models vs. Real World
Yellen’s press conference was panned by some as confusing and ambiguous. I personally would have given her an A+ had she not made the critical unintentional mistake of reintroducing a time frame. Her stumble pushed her grade to B+. When repeatedly pressed during Q&A to explain what “considerable time” meant, she stumblingly said “six months”.
- The market naturally re-priced by moving forward expectations of the first rate hike from August 2015 to April 2015. This is because, at the current pace of ‘tapering’, April coincides with the date that is six months after QE ends.
Although she never should have specified an absolute time frame, the market should not have been surprised that “considerable period” corresponds to around “six months”. Bernanke borrowed the language from Greenspan who first used the language “extended period” in 2003. They defined it as “2 or 3 meetings” and as “at least six months”.
- Furthermore, in the Fed paper, “The Federal Reserve’s Balance Sheet and Earnings: A Primer and Projections”, the Fed outlined exit strategy assumptions which suggested a period of six months between actions.
The press conference was not as “boring” as some have stated, because the FOMC (represented by Yellen) now appears to be struggling between theory and practice. This marks a significant shift from the majority of members who had almost entirely been relying on models (theory). Several had seemed intent on providing stimulus until economic targets were met without sufficiently questioning the effectiveness of such policies, or their potential consequences. There were hints yesterday that the FOMC now recognizes (practice) that the economy, labor markets and the markets may have stresses that are not picked up adequately by models. This is a positive sign. Yellen again admitted that it is hard to know the magnitude of structural factors impacting unemployment.
It must be exceedingly difficult for one person to collectively represent the highly dispersed views of 19 committee members. In addition, navigating the press conference as the FOMC is in the initial stages of a policy pivot makes it even more difficult. What is even more impressive is the fact that she is operating in the midst of the most extreme policy initiatives in the Fed’s history while other unprecedented imbalances and pressures exist in China and Japan (not to mention elevated geo-political tensions). Her vagueness was actually informative (because that is ‘qualitative guidance’). Yet she still showed an ability to discuss a wide range of views. For all of these reasons, I gave her high marks.
The one thing that seemed perfectly clear is that the Fed plans to continue to unwind the QE program barring some type of disaster. After that, we will all have to reassess and see how things unfold.
The FOMC’s Global Challenges
A confluence of highly concerning factors are all colliding simultaneously, adding to Yellen’s challenges.
Massive fiscal and monetary stimulus in recent years have skyrocketed asset prices, but yet developed world economies have only been able to muster 2.5% growth. The rate of global stimulus in now in decline.
EM central banks (and the RBNZ) have hiked rates.
The FOMC is tapering.
Japan is raising its consumption tax on April 1st (the third arrow is nowhere in sight).
Geo-political tit-for-tat with Russia could spiral out of control. Russia could cause trouble in the Middle East in an attempt to lift oil prices. This would hurt the west (and economic growth), but strengthen the Russia economy.
Beijing has decimated levered carry trades by unexpectedly weakening the Yuan. Beijing is also allowing defaults. The era of riskless borrowing has come to an sudden end. If Beijing is not careful, deeply interconnected cross guarantees could unleash an uncontrollable wave of bad loan defaults. After many years of moral hazard that have fueled the credit bubble, lenders will be more careful. Growth will surely slow but Beijing is trying to prevent a hard landing.
Most investors are expecting a march to higher Treasury yields in the near term, but I think they will be disappointed. For the next few weeks, I still prefer: long 30-yr Treasuries; curve flatteners; long the dollar; and long Treasuries vs. Bunds.
“Theory is when you understand everything, but nothing works. Practice is when everything works, but nobody understands why. When theory and practice are untied, nothing works and nobody understands why.”