Just when it looked like we might be rolling over, we awaken to another day of up 10 handles in the spoos.

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Yesterday had the feeling that the market might crack to the downside, but an afternoon rally into the close saved the day.

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I still stick to my forecast that the next month of two is going to frustrate both the bulls and the bears. I don’t think you chase you rallies, nor do you try to pile on declines…


Jackson Hole shift?

That benign forecast has one important caveat. The market is expecting Janet Yellen to ever so slowly raise rates. Remember, the market is pricing in rate raises that are less than the Fed’s forward forecasted rates. This means that the market does not believe the Fed will be as aggressive at hiking rates as they say they will be. Yellen’s reputation of a dove is superseding the Fed’s desire to guide rates higher.

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It is astounding that short term interest rate futures continue to drift higher even as the good economic news piles up.

This constant creeping higher of short term futures is the result of a market that expects Yellen to err on not raising rates too quickly for fear of snuffing out the “what they believe to be” fragile recovery. This paragraph from the Tim Duy’s Fed Watch blog sums up the consensus view:

The Kansas City Federal Reserve’s annual Jackson Hole conference is next week, and all eyes are looking for signs that Fed Chair Janet Yellen will continue to chart a dovish path for monetary policy well into next year. Indeed, the conference title itself – “Re-Evaluating Labor Market Dynamics” – points in that direction, as it emphasizes a topic that is near and dear to Yellen’s heart. My expectation is that no hawkish surprises emerge next week. Despite continued improvement in labor markets, Yellen will push the Fed to hold back on aggressively tightening monetary policy. And with inflation still below target, wage growth constrained, and inflation expectations locked down, she holds all the leverage to make that happen.

I am not nearly so sanguine about the possibility of the Fed becoming more aggressive in regard to hikes, but I am probably making the mistake of assigning my own beliefs of what must be done onto the Fed.

There is no doubt that Yellen herself has given few hints of wanting to guide the yield curve higher. The correct bet is for her to pull a “Thelma and Louise” and drive the economy right off the cliff into monetary madness.

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Too often I have made the mistake of assuming that authorities will do the “right thing” and take the more prudent road. But this has more often than not cost me money.

I am going to go through the logic of why Yellen might use Jackson Hole as a chance to guide the market towards a tighter monetary policy, but this is an outlier possibility.


The case for a hawkish shift at Jackson Hole

The market has conveniently forgotten that at the beginning of their terms, the two previous Fed Chairman also had reputations as uber doves, yet both of their first moves were to tighten policy. Greenspan tightened into the 1987 stock market crash. Bernanke raised rates into the 2008 credit crisis. There is often a mistaken belief that the new Fed Chairman will be looser than the previous one. Maybe that is correct assumption in the long run, but at first they often err on trying to show the market that they are committed to both sides of the Fed’s mandate. I must admit that so far Yellen has showed absolutely no signs of being concerned about the market’s pigeoning her into the role of uber dove, but if she follows the recent history, she will be disappointing the market soon enough.

The legendary trader Stanley Druckenmiller gave a recent speech where he argued that the current monetary policy is stupidly too loose. His argument was that if you were on another planet for the last decade, upon returning and being given the current economic stats, what would be your guess of the Fed Funds rate? Maybe 3%, maybe 4%, maybe even 5%. But certainly not zero! Monetary policy is absurdly low. Full stop. The ZIRP was an emergency measure, but here we are five years later with the policy still in effect. Everyone lambasted Greenspan and Bernanke for leaving rates too low for too long during the last cycle, but here we are doing the exact same thing – only worse! Rates should be higher and the sooner the better. Eventually Yellen is going to have to succumb to this reality, and Jackson Hole is as good as a time as any to guide the market higher.

Yellen’s reluctance in raising rates is due to a poor employment picture. But we are seeing continuing claims hitting 10 year lows!

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I know that the employment picture is much more complicated than just claims, but yesterday’s JOLTS data also pointed to a much better labour market.

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Everything is heading the right way in terms of employment. Maybe leaving rates at emergency low levels of zero for an extra six months is not going to help the structural employment problems that Yellen is still focusing on.

Which brings me to the rest of the Fed. Yellen is the Chairman, but there are still a group of other Fed Governors that are responsible for voting on monetary policy. When trying to gauge the total employment picture, many Fed governors use a wide array of different inputs. JOLTS data plays an important role. Have a look at this spider graph from the Atlanta Fed. The JOLTS data is three of the inputs.

http://themacrotourist.com/images/Azure/AtlantaAug1314.png

The data is piling up against leaving rates at zero, and if Yellen doesn’t take a step towards the hawks, then eventually there will be some serious conflict within the Fed.

Many expected noted hawk Richard Fisher to dissent at the recent FOMC meeting. However, he did not. I can’t find the quote, but when asked to comment, he said something about being satisfied about the course the Fed has set. I wonder if Yellen has placated Fisher by agreeing to set the stage for higher rates at Jackson Hole?

As I mentioned, the odds do not favour Yellen surprising the markets at Jackson Hole. It is probably not the right bet, even though it is probably the correct policy.

However, you should be ready for that possibility. If not this summer, then when?


Positions

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