Fed: Supply-Side Yellenomics Is (Slowly) Losing Its Grip On Markets by Tony Crescenzi, PIMCO

  • The Fed worries that if it raises rates prematurely, it could prompt a disorderly exit by investors who for many years ventured ever outward along the risk spectrum (at ever higher prices, mind you), harming economic growth.
  • The Fed recently demonstrated that it is sympathetic to much that has been worrying markets. It lowered its projection for its policy rate and also lowered its forecast for economic growth and inflation.
  • When constructing portfolios, we suggest investors stay focused on the potentially (slow) speed and (low) magnitude of future Fed rate hikes, as well as the outlook for rates around the world, rather than the timing of the Fed’s initial hike.

Should investors worry about the possibility that the Federal Reserve might raise interest rates this year? How about the negative economic consequences of the rally in the U.S. dollar? “Hawkish” Fed mistakes?

Well, the Fed can’t keep its grip on markets forever, and it doesn’t want to, either. Indeed, the era of “Yellenomics” rooted in excess labor supply justifying extraordinary accommodation is slowly coming to an end.

That said, when constructing investment portfolios we suggest investors stay calm and focus on the path of the Fed’s policy rate and its ultimate destination, as well as policy rates abroad, which are likely to stay low for the rest of the decade, compelling investors to keep reaching for higher yields and returns. In addition, look for opportunities to arise in equity and credit markets when markets inevitably become anxious in response to a Fed rate hike.

Yellen and the FOMC offer a soothing statement

Ever cognizant of its influence on financial markets, the Fed, in both its March 19 policy statement and its quarterly Summary of Economic Projections (SEP), demonstrated that it is sympathetic to much that has been worrying markets of late, and Janet Yellen in her post-FOMC press conference put an exclamation point on it.

Most soothing for investors was the lowering of the Fed’s projection for its policy rate, the federal funds rate. Specifically, the Fed lowered the cumulative amount of rate hikes it expects to implement this year and through 2017 by about half of a percentage point. Sensibly, the Fed also lowered its forecast for economic growth and inflation (see Figure 1). The Fed obviously has a few worries of its own.

Fed

Showing it recognizes it is not blind to its influence in the global sphere, the Fed also expressed concern about “international developments” and the negative impact that the dollar’s recent rally is having on U.S. exports, a worry that seems well-placed given recent trade data (see Figure 2).

Fed

By elevating the dollar and international developments to the level of the policy statement, and to the SEP and Janet Yellen’s press conference, the Fed is now more aligned with market sentiment on these matters. This demonstrates the importance the Fed places on financial conditions in its formulation of monetary policy. While the Fed can’t be held hostage to the financial markets, it knows it must show deference to them, because its policies transmit through markets into the economy. This happens through these five channels in particular:

  1. Stock prices
  2. Bond yields
  3. Credit spreads
  4. Lending standards
  5. The value of the U.S. dollar

It’s that fifth channel – the value of the U.S. dollar – that lately is getting the most attention, even though the other four have a far larger bearing on economic activity (see Figure 3).

Fed

Given its influence on markets, the Fed worries that if it raises rates prematurely, it could prompt a disorderly exit by investors who for many years ventured ever outward along the risk spectrum (at ever higher prices, mind you), harming economic growth. The Fed has experience in this regard from the “taper tantrum” of 2013, when markets swooned on indications the Fed might end its bond-buying program. Notably, markets eventually strongly rebounded.

Yet, out of an abundance of caution, to manage the risk of a rate spike, as well as to safeguard the substantial progress seen on the economic front, the Fed these days is taking no chances: It is working exhaustively to convince investors to continue doing what they have done in recent years and in fact for centuries, which is to take a leap of faith and stay invested in hopes of making a profit, chiefly by aiming to convince investors it will move cautiously on rates.

Supply-side Yellenomics is (slowly) losing its grip on markets

The recent rally in the U.S. dollar indicates very clearly that the Federal Reserve’s post-crisis efforts to influence market prices are giving way to more traditional influences and in particular economic data and underlying economic fundamentals. For almost eight years, the Fed through its bond buying and zero interest rate policy has aimed to influence markets on several fronts:

  1. Reduce forward rate expectations
  2. Suppress interest rate volatility
  3. Compel investors to move outward along the risk spectrum

Now, because of the cumulative progress seen in reducing economic slack and in particular in getting people back to work, the Fed can no longer sustainably keep investors from pricing in an eventual rate hike. For now, this is manifesting itself mainly in the value of the U.S. dollar, where a divergence in the path of monetary policy in the U.S. versus that of Europe and Japan has become prominent – while the Fed is poised to raise interest rates, the European Central Bank and Bank of Japan are continuing to ease policy and they are years away from rate hikes of their own.

The dollar’s surge suggests that market participants believe the U.S. economy is inching closer to full employment, which in the Fed’s eyes will be reached when the unemployment rate is between 5.0% and 5.2% (see Figure 1 again). In other words, fundamentals – not the Fed’s words, mind you – are increasingly driving market prices.

The era of the Fed providing substantial near-term forward guidance is over. It has given way to economic data, and now every Fed meeting is “live.”

Therefore, with the underutilization of labor resources continuing to diminish, the Federal Reserve’s ability to control market prices will diminish, too, because markets will expect the Fed to end its emergency policy rate, and this will be the major driver of market prices rather than the Fed’s forward guidance. This is in contrast to recent years when the Fed easily convinced investors it would keep its policy rate at zero using the argument that wages and thus inflation would be kept down by a vast supply of untapped labor. Now, with the jobless rate at a relatively low 5.5%, this argument is becoming less potent a force in shaping market prices.

Yellenomics – in other words, the Yellen-era policy framework that utilizes the supply argument as a rationale for maintaining an extraordinarily accommodative stance on monetary policy – is on the wane, albeit slowly, because the debate over labor supply is moving from one of obvious abundance to one that is less obvious.

The U.S. jobless rate is the most convincing example, even if a somewhat flawed indicator (see Figure 4).

Fed