On Friday Fed Chairwoman Janet Yellen gave a speech in Rhode Island. Although it would be foolish to expect any change in policy at this sort of speech, it was still a chance to gain a better understanding at how Yellen sees the economy unfolding. As I listened to the speech, a moment of dread for my long US dollar position immediately overcame me as Yellen’s words hit the tape:
In recent months, some economic data have suggested that the pace of improvement in the economy may have slowed, a topic I will address in a moment. And even with the significant gains of the past couple years, it is only now, six years after the recession ended, that the labor market is approaching its full strength.
I say “approaching,” because in my judgment we are not there yet. The unemployment rate has come down close to levels that many economists believe is sustainable in the long run without generating inflation. But the unemployment rate today probably does not fully capture the extent of slack in the labor market. To be classified as unemployed, people must report that they are actively seeking work, and many people without jobs say they are not doing so–that is, they are classified as being out of the labor force. Most people out of the labor force are there voluntarily, including retirees, teenagers, young adults in school, and people staying home to care for children. But I also believe that a significant number are not seeking work because they still perceive a lack of good job opportunities.
In addition to those too discouraged to seek work, an unusually large number of people report that they are working part time because they cannot find full-time jobs, and I suspect that much of this also represents labor market slack that could be absorbed in a stronger economy. Finally, the generally disappointing pace of wage growth also suggests that the labor market has not fully healed.
I quickly realized Yellen was clearly signalling there would be no June hike, and September was more touch and go than I previously believed. My mind raced with worries of “oh crap, she is more dovish than I thought – I am going to get smoked on my long US dollars.”
But much to my surprise, the US dollar rallied hard as Yellen’s comments were digested.
Lately I have been droning on about how the market does not believe the Fed is serious about raising rates, but I had no idea the extent of the disbelief. Yellen’s speech on Friday was about as dovish as you could get. She ruled out current improving labour conditions as sufficient for a rate hike. The idea of the emergency zero rate being taken off the table because the economy was good enough was firmly squashed. This should have been interpreted as more easy money policy from the Federal Reserve.
Notice how I said “should have been interpreted?” I just uttered some of the most dangerous words in a trader’s vocabulary. The moment you start expecting the market to behave a certain way means you have stopped listening to the market. Sometimes bullish news is bullish, and sometimes it is bearish. It all depends on what has been built into the price. The real key to trading is figuring out what the market has already discounted, and figuring out where the most likely surprise will come from.
I thought Yellen’s speech was dovish, but that doesn’t mean squat. What is infinitely more important is how the market interpreted the speech. And in that regard, the market has become so convinced the Fed does not have the guts to raise rates the following part of Yellen’s speech overshadowed all the other dovish mutterings:
Given this economic outlook and the attendant uncertainty, how is monetary policy likely to evolve over the next few years? Because of the substantial lags in the effects of monetary policy on the economy, we must make policy in a forward-looking manner. Delaying action to tighten monetary policy until employment and inflation are already back to our objectives would risk overheating the economy.
For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term.
Yellen’s signalling a rate hike later in the year was all the market could focus on. Forget about the dovish “employment is still not strong enough” madness, her saying out loud that rates will most likely be going higher later in the year was the surprise that moved prices.
This market is much less prepared for rate hikes than even I imagined. When the hike finally does come, the reaction will be much larger than many pundits forecast. The reaction to Yellen’s speech is indicative at how dovish they expect her to be. She has lost all credibility of being able to pull the trigger on a hike.
This skepticism offers a great opportunity. I continue to believe the market is underestimating the chances of higher short term rates.
Commitment of traders report
This week’s CFTC Commitment of traders report confirms the idea that speculators refuse to believe a Fed rate hike is coming.
The specs continue to unwind their long US dollar positions:
The short term interest contracts show speculators betting on lower rates, not higher.
Both of these trades offer plenty of room to move the other way once speculators realize the Fed will raise rates in the coming months.
One of my favourite weird relationships I like to watch is the platinum/gold ratio versus the US Treasury yield.
So far the uptick in yields has not been met with an increase in the platinum/gold ratio.
The chart for platinum is far from healthy looking:
I don’t know if the relationship between platinum/gold ratio and US treasury yields is going to continue to track, but either bonds are about to rally, or somehow the platinum/gold ratio will get up off the mat. Given the terrible looking platinum chart I certainly hope it isn’t by gold puking…
Thanks for reading,