What Went Wrong Yesterday

As it turned out Janet Yellen did in fact shock the market, and not just once but twice, when her initial "hawkish" comments were reappraised as very dovish, after the market focused on the language discussing the purchase of "other assets" in the future, which however was followed by an anticlimatic hint of a "September rate hike" from Stanley Fischer, who promptly killed the market's post-kneejerk euphoria.


So what went wrong? Citi's Steven Englander explains:

What's gone wrong?

  • Market (and I) expected Fed hike discussion to  be centered on December and it turns out September and maybe September and December are more in play than thought
  • Fischer comment in response to Liesman’s question on possibility of September/two hikes: “ I think what the Chair said today was consistent with answering yes to both of your questions, but these are not things we know until we see the data.”  What isn’t clear is if he actually was speaking on Yellen’s behalf. The language could, but does not necessarily, imply this.
  • Investor debate is whether they are putting September on radar screen because
    • they think it should be live or
    • it is hard to look apolitical if you preclude a hike after strong economic numbers, but will find a reason not to hike when push comes to show
    • Will pass on September but tee up December
  • Market had trimmed long risk positions a bit, but probably bought some back before Fischer comments hit the air so position cutting when equities and bonds reversed was brutal.


I still think they will hold in September, but they clearly want it to be more live. As long as the odds are rising,  we are likely to see pressure on EM currencies and USD strength. The world of bond and equities selling, and rising risk aversion, is a nasty one for high yielding EM. We could also have a discontinuity between the Friday close and Sunday open depending on what further comments are made. The discontinuity could be in both directions if Fed speakers come out dovish again, even if the extent of the dovishness is to emphasize December or September, but the biggest pain is if  the string of hawkish September comments continue.


Separately, there is some pushback on the idea that Yellen is prospectively advocating buying equities and bonds as a way of augmenting monetary policy in the next downturn.  But I think she is defending the current framework against those who argue that the long period of low rates leaves them with no ability to respond to a slump. Williams said make policy aim for higher inflation, other talks about nominal GDP; Reifschneider shows room for stimulus if you get fed funds to 200-300bps but by implication if fed funds starts lower stimulus is ineffective. 

Her response is that they have additional tools that they can deploy – i.e. buying other assets. Note her full quote (my bold):

“On the monetary policy side, future policymakers might choose to consider some additional tools that have been employed by other central banks, though adding them to our toolkit would require a very careful weighing of costs and benefits and, in some cases, could require legislation. For example, future policymakers may wish to explore the possibility of purchasing a broader range of assets.”

So the answer to ‘How do you stimulate the economy when there are no more conventional rate or unconventional QE/forward guidance tools?’ is ‘Broaden the set of assets that you can buy”. And while Congress may be unwilling when the unemployment rate is under 5%, they may be more willing at 7% if a recession is underway….and this means they can continue to do slow and unsteady hikes, based on the current framework. It also negates (at least in theory) analysis that says you can’t raise rates near zero because the cost of a mistake is too high. You have a fall back which is buying other assets.

In other words, all Wall Street believes the Fed will need to "purchase a broader set of assets", is for a recession to hit, which will promptly force Congress to change the appropriate legislation (as hinted by Yellen) and expand the universe of assets eligible for Fed monetization. Which means that as of this moment, the big money is "axed" to push for the opposite of a recovery.

And even if that does not happen, the Fed can simply fall back to its tried and true TSY QE. Conveniently, earlier this week's Fed staffer David Reifschneider calculated how much the next QE would have to be, in order to offset a sharp US recession: $4 trillion, or more.