Contrary to most market participants’ belief of Yellen as some sort of uber dove, she once again proved her tone deafness with yesterday’s speech.
First, after years of a slow economic recovery, you are entering the strongest job market in nearly a decade. The unemployment rate, at 4.6 percent, is near what it was before the recession. This is a level that has been associated with good job opportunities. Job creation is continuing at a steady pace; the layoff rate is low; and job openings are up over the past couple years, which is another sign of a healthy job market. There are also indications that wage growth is picking up, and weekly earnings for younger workers have made strong gains over the past couple of years. That is probably one reason why younger workers reported feeling significantly more optimistic about the job market compared with 2013, according to a survey published just today by the Federal Reserve.
Yeah, I know Janet was giving a commencement address, so a certain degree of optimism was required out of basic politeness, but the markets took her remarks as an upgrade of her assessment of the employment environment. When you combine this change of outlook with her staunch denial the other day that she would allow the economy to run hotter for longer, the market has correctly interpreted her latest remarks as further guidance short rates will continue rising.
The yield curve, which had been trying to bounce from her earlier FOMC Q&A about-face, quickly gave up the recent hard fought gains.
You might think that given the delicate situation in Italy where the world’s oldest bank is desperately trying to raise capital for a massive restructuring, Yellen might throw Europe a bone and ease off on the hawkish rhetoric, but no such luck.
I am aware the Federal Reserve sets policy for the United States and is not responsible for the global financial system, but unfortunately with the privilege of being the world’s reserve currency comes some responsibilities. Yet Yellen and her colleagues seem oblivious to the damage her policy is reaping on the rest of the world.
And nowhere is this more evident than China. The Federal Reserve tightening cycle has been brutal on China.
China kept their loose peg to the US dollar for too long, and although they have now re-calibrated it against a basket of currencies, the damage has already been done. China needs a lower exchange rate, and the Fed raising rates only exacerbates the problem.
As Yellen keeps her foot on the throat of the global economy with higher rates and more hawkish rhetoric, the pressure intensifies for China to devalue their currency.
In the mean time, Chinese money markets are being starved of liquidity as the PBOC valiantly tries to stop the Yuan from plummeting.
The signs of the stress are everywhere.
Last week Chinese bond futures were halted as selling became too intense.
I might be willing to overlook the Chinese long end declining as many bond markets are struggling for oxygen in the current global bond bear market.
But it’s the short end of the Chinese yield curve that is most worrying.
The two year spread between swaps and Chinese government bonds has blown out. This crude “TED” spread measures the stress in bank funding.
Two year swap spreads are exploding higher. When you step back and look at the longer term picture, it becomes evident this is no regular widening. The spread has hit all time wides.
It’s not getting much press, but late last week the People’s Bank of China made some emergency liquidity injections to quieten the disarray in money markets. From the WSJ:
China’s central bank extended hundreds of billions of yuan in emergency loans to financial firms on Friday and ordered some of the country’s biggest lenders to extend credit as well, as it moved to ease a liquidity crunch and continuing debt selloff.
The moves marked a second day in which the People’s Bank of China pumped money into the financial system and markets, after the U.S. Federal Reserve signaled it might quicken the pace of its rate increases. That in turn spooked Chinese investors who were already worried about government attempts to let the air out of a highly leveraged and overheated bond market by tightening credit.
On Friday, the PBOC tapped an emergency lending facility it created in 2014 to extend 394 billion yuan ($56.7 billion) in six-month and one-year loans to 19 banks. That pushes the net amount extended through the facility to 721.5 billion yuan so far in December, a monthly record, according to Beijing-based research firm NSBO.
The PBOC also ordered a few large banks to extend longer-term loans to nonbank financial institutions, while China’s securities regulator asked brokers tasked with making a market in bonds to continue trading and not shut any companies out of the market, according to Mr. Zheng of Dongxing Securities.
The central bank also injected a net 45 billion yuan into the money market on Friday, following a net 145 billion yuan cash infusion on Thursday.
“The whole market is scrambling for liquidity and the PBOC is ready to do more to calm the market,” said Arthur Lau, head of Asia ex-Japan fixed income at PineBridge Investments in Hong Kong.
Right now everyone is all bulled up with Trumphoria, but these developments in China deserve some caution. As the Federal Reserve tightens, something will break. Maybe it won’t be in the US. Maybe it will be the world’s second biggest economy. Either way, keep your eye on Chinese money markets. They are way more important than the market realizes.
Thanks for reading,