One thing I love about writing this newsletter is that it keeps me intellectually honest. No making grand predictions and then quietly shirking away when they don’t work out. My mistakes are sitting there in black and white for everyone to see.
And yesterday’s call about Yellen & Co. erring on the hawkish side was about as bad a forecast as I could have made. It was completely and utterly wrong. Embarrassingly wrong. Not quite as embarrassing as when during the early 1980s the missus and I posed for the cover of CPU magazine, but embarrassing nonetheless (it was suppose to be tasteful… you know artsy… in a geeky kind of way.)
The MacroTourist and missus posing for a tasteful arty cover</a> </div>
There was every reason in the world for Yellen to err slightly on the hawkish side, but not only did she turn her back on that opportunity, she couldn’t even straddle the line and stay the course. Instead she doubled down on her “we will be easy for some time to come” policy.
Let’s first look at why I thought that Yellen might lean a little hawkish, at least when it came to winding down QE.
Although I understand that unemployment is still running significantly higher than during the last recovery, the Fed itself put 6.5% out there as a target rate for normalizing policy. Last I checked, the unemployment rate was poised to hit that target any moment:
US Unemployment Rate</a> </div>
And then when it comes to the other half of the Fed’s mandate, inflation has been creeping up and is now sitting above their 2% threshold:
US YoY CPI</a> </div>
Not only that, but forward looking indicators like MIT’s Billion Prices Project are forecasting increasing inflation:
MIT Billion Prices Project</a> </div>
Given that the QE program has generally been derided as exacerbating the inequality program by pumping money onto Wall Street, I thought that the recent uptick in both inflation and employment would give Yellen some ammo to wind down the unpopular QE program more quickly than forecast. At the least I thought that she would simply stay the course and stress the risks to both sides of the economic landscape.
Instead, in an absolute stunning press conference, she showed her true colours that all the gold bugs have been warning about.
I am not going to bother parsing each utterance, but when answering the reporters’ questions, Yellen consistently responded in the most dovish way possible. She repeatedly stressed that employment was no where near the long term average. On the topic of inflation, she chose to label the recent uptick as “noise” and claimed that inflation expectations were running below the committee’s objectives of 2%. When a reporter asked whether the FOMC would allow an inflation overshoot if unemployment stayed high, the answer was a convoluted yes.
Basically Yellen reaffirmed and doubled down on the “we are going to stay easier for longer” policy.
Slowly Bill Gross’ theory that the long term natural neutral rate is dramatically lower than in previous cycles has seeped into the FOMC’s thinking. As we can see from the FOMC members’ forecast for the Fed Funds rate in the coming years (the infamous dot chart), not everyone is yet on board, but there are a stunning number of Governors who have extremely low forecasts.
The FOMC forecast of Fed Funds by Governor</a> </div>
There are three governors who are forecasting no increase in the Fed Funds rate in 2015 and half of them have the rate at 1% or below. When it comes to 2016, we still have three of them that are forecasting a Fed Funds rate below 1.5%.
The idea that inflation is no longer a threat and that rates can stay this low for this long with no significant uptick in inflation is the final piece of the puzzle that is required for the next big policy error. If market participants were convinced that the Fed was worried about inflation, then it would be very difficult to actually create inflation. The moment that inflation perked up, the market would front run a Federal Reserve policy response and tighten monetary policy. This would arrest any developing inflation.
Without the Federal Reserve’s willingness to tolerate inflation, the natural state of debt destruction would overwhelm any inflationary uptick.
I am not sure if the Yellen & Co. know about the can of worms that they are unleashing, but in reality they have no choice. Without a full commitment of balls to the wall monetary easing, it will be very difficult for the economy to ever break out of its under achieving status. As Paul McCulley stated many years ago, “the Fed needs to be responsibly irresponsible.”
Whether they understand it or not, the FOMC has now become responsibly irresponsible.
Yesterday as I listened to Yellen’s Q&A, I immediately started adjusting my portfolio.
Although I am sympathetic to the idea that Yellen’s press conference might create a feeding frenzy in stocks, I feel that there are other assets that are much less crowded that offer better risk rewards.
I don’t think anyone should be long US dollars in any shape or form. My CAD short had not worked as expected, but I immediately covered it in its entirety. I then decided I need to be long some currency. Although I hate myself for doing so, I bought some EUR. I don’t seem to be ever able to trade this currency profitably, but given the recent increase in EUR bearishness, I felt that this was a good dip to buy.
EUR – good dip to buy?</a> </div>
But the trade that I really doubled down on was my gold stocks. I bought even more GDX.
Yellen has just told you that come hell or high water, she is going to do everything she can to “fix” the economic sluggishness. Of course it is not going to work and she is just going to create inflation, but they don’t really have any choice.
Gold and the gold stocks are extremely out of favour, and apart from the Charlton Heston gold bugs that will be buried still clutching their gold bars, no one likes the sector.
Yellen very well might turn out to the gold bug’s best friend…
GDX – Gold Miner ETF</a> </div>
Yesterday was one of those dramatic days when the direction of the next move becomes clear. Although some might argue that you should buy stocks on the headlines, don’t forget that markets often top in the midst of good news. I am not going to keep fighting the rise, and I will just be thankful that I am long puts instead of outright short stocks. But by no means am I going to chase equities up here. Some might argue that you should buy bonds because Yellen has just told you that rates are going to stay lower for longer, but don’t forget what a bond market’s greatest enemy is…
Yellen has just told you she is going to create inflation. It is time to stick the “long real assets short financial assets” trade on in size.
Don’t overthink this. Don’t be tempted to chase extended financial assets. Go buy some real assets that will benefit from the coming inflation.
S&P 500, Fed Balance Sheet and the CRB</a> </div>
Yellen’s refusal to even entertain the idea that they might be erring on the side of being too accommodative is like your teenaged boy claiming that the keg party, the neighbours’ complaints about loud music and the roping off of the street for a drag race is all just “noise” and that nothing bad will come of it. Maybe he will be right, but it is not the right bet.