Wow! That was a shocker of a speech by the head of the world’s most important central bank. And it has some serious investment implications for you.
Yesterday at the Economic Club of New York, Janet Yellen put her true colors on full display for the world to see. Chair Yellen announced that she was an unabashed dove on monetary policy. Easy money is her default stance, and activist policy is her forte.
Inflation and employment data—once the justification for years of zero rates and quantitative easing—no longer serve the Fed’s purpose.
It’s on to new and different “data” to explain to the millions of savers and retired investors why it is for the greater good that they must continue to be paid crumbs on their life’s savings.
Yellen’s ultra-dovish stance was received positively by investors. U.S. stocks surged on the news. Gold popped and global equities soared overnight. Government bond yields plummeted. Investors now aren’t even sure if there will be a single interest rate increase this year. A seeming 180° turn from the Fed’s proposed policy only three months prior.
Yellen has issued a new license to speculate. The FANG stocks are back in favor and they have been joined by Tesla—another favorite of the pie-in-the-sky crowd. Maybe we can call them the GNATs—a more appropriate description in my opinion.
Don’t fight the Fed is Wall Street’s response to Yellen’s speech, but is that a sound long-term investment strategy?
I think not.
According to tried and true models of short-term interest rates, the Fed is already way behind the curve on interest rate hikes. The so-called Taylor model says short-term interest rates should be over 3.5% today. The Fed had loosely followed the rule for years with success, until Bernanke got his grubby mitts on the institution.
Instead of adhering to the 3.5% recommendation of the Taylor rule, rates are at 0.50% today. Why is the Fed so far behind the curve?
The obvious, yet unspoken explanation is that it is an election year, and Ms. Yellen is a lefty. What’s more, the leading candidate on the right is the antithesis of the collegial Federal Reserve. If it takes a little nudge of monetary stimulus to keep Trump out of the Oval Office, so be it, Ms. Yellen might be thinking.
You of course won’t read that in the mainstream press. There is either too much naiveté or complicity for the mainstream press to follow that line of questioning. But when you examine Yellen’s justification for continued easy money, you can’t help but think there is a hidden agenda. She laid it all out in her speech yesterday. I’ll spare you the Fedspeak and instead provide a few of the highlights.
- Yellen doesn’t believe the rising trend in core inflation is durable. To wit, “In contrast, core PCE inflation, which strips out volatile food and energy components, was up 1.7 percent in February on a 12 month basis, somewhat more than my expectation in December. But it is too early to tell if this recent faster pace will prove durable.”
- Despite the unemployment rate being at target, Yellen doesn’t believe the rate is an accurate reflection of the labor market. “Currently, the median of FOMC participants’ estimates of this rate is 4.8 percent. However, this longer-run rate cannot be estimated precisely, and so it could be appreciably higher or lower–although given low readings on wages in recent years, I think the latter possibility is more likely than the former. If so, a lower level of unemployment might be needed to fully eliminate slack in the labor market, drive faster wage growth, and return inflation to our 2 percent objective.”
- Yellen now believes low oil prices are not the boon to the economy they once were. Her belief is based at least in part on her interpretation of the stock market’s recent reaction to low oil prices.
- Yellen is extremely confident (err…overconfident) in the Fed’s ability to control inflation should it rise and seemingly unconcerned about what rapid rate hikes would do to the economy.
- Global growth is at the forefront of Yellen’s dovishness today, when historically it was only a marginal consideration.
- Yellen believes the January and February stock market correction that is now ancient history could still weigh on economic growth.
- Yellen says the neutral interest rate, the rate that prevents the economy from overheating is now much lower than it has been for decades.
Yellen is of course the chief at the Fed, and her word must be taken seriously, but she is on real shaky ground if she is going to try to justify ultra-loose policy on the basis of what basically amounts to, I don’t believe the data and the old economic relationships no longer apply. Many of her colleagues don’t share these views and some are out of the mainstream.
That puts Yellen out on a limb and creates the risk of yet another reversal of Fed policy and a reversal of the easy-money trade in markets. Fed dovishness has helped stocks recover from their February lows and pushed bond yields lower. Investors now doubt that the Fed can get rates above 1.25% by 2018. That may turn out to be true, but it’s already priced into stocks and bonds. Further upside may be limited while a faster rate of interest rate hikes could cause serious downside. Manage risk accordingly.
Jeremy Jones, CFA
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