Most market watchers believe Janet Yellen to be an uber dove. I don’t hold the same view. Since taking office she has consistently erred on the hawkish side. During this period, she has tapered, and ended Bernanke’s third quantitative program. Yellen then prepared the market for the first rate hike in a decade, and finally pulled the trigger amid many influential pundits’ warnings (Summer, Dalio to name a couple). Not only that, but she refused to signal a “one and done” lift off. This hawkishness was the main reason for the January 2016 market dislocation.
Her hawkishness has been a mistake that sent the US dollar soaring, and in the process created problems as other Central Banks desperately tried to offset Yellen’s tightness with their own easing. These diverging policies caused the US dollar to soar even higher, putting further deflationary pressure on many commodity prices, and created a vicious self reinforcing cycle.
Yet the narrative of Yellen the uber dove seems to hold much more credence than my belief she has been too tight. But if you examine the short end of the yield curve, it is tough to hold the opinion she has been easy. Here is a chart of the US 2 year yield minus the 90 day T-bill yield. This spread does a good job of measuring the expected Fed tightening.
The trend higher is obvious and flies in the face of the picture of Yellen the uber dove.
But she blinked
The terrible start of risk markets in 2016 was the direct result of the FOMC board’s over eagerness to raise rates. Given that no country has ever successfully retreated from a Zero Rate Interest Policy (ZIRP), it would have been more prudent to take much more of a hike and wait policy. Instead Fed officials kept talking up rate hike expectations, and in the process caused a global market dislocation that ultimately forced them to retreat from their aggressive stance.
There is no doubt that Yellen had a look at the pain her policy was causing throughout the globe, and blinked. Check out this great chart from Deutsche Bank that highlights the number of times Yellen mentioned various keywords in her recent speeches:
The usage of the words “global”, “China” and “dollar” skyrocketed at her pivotal March 29th speech. Yellen correctly realized the Fed was tightening too quickly.
I think her timing stinks, but better late than never.
Here’s the problem as I see it. Now that Yellen has rescinded her aggressive tightening policy, the market has assumed it has not only been paused, but instead reversed. The idea Yellen will now assume her supposedly inherent dovish policy stance is increasingly been built into the market. All you need to do is look at the response of the various Fast money “experts”:
Suddenly there is near a unanimous belief that Yellen and the FOMC board’s desire to normalize rates has vanished, not to return anytime soon.
Risk vs. reward
I am not nearly smart enough to know if the Fed’s over eagerness to normalize rates will prop back on the radar in the coming months. But I know if the US economy continues to be moribund, the market will not be surprised. The US dollar will probably drift a little lower, and maybe the US yield curve gets even more flat. The market’s expectations will be met and therefore prices will not need to adjust by large amounts.
What scares me more is a global economic uptick. The world economy is due for a bounce. And a big one at that. In their attempt to offset Yellen’s unnecessary hawkishness, the ECB and BoJ have thrown a mind boggling amount of monetary fuel into the system. This is combined with many other Central Banks who have aggressively lowered rates. And for the first time in a long time, some governments (Canada for example) have even taken out the fiscal stimulus chequebook. To top it all off, eventually the lower oil price will result in more economic activity. All of these influences just take some time to play out.
If I am correct about an imminent global economic rebound, the Fed will find themselves in an uncomfortable spot. Don’t forget these are the same jokers who were guiding higher even when things were looking increasingly bleak. What sort of pressure will they feel if the economy actually improves?
Most importantly, the market is no where near prepared for this possibility. All of the US dollar bulls have abandoned their position.
I can’t tell you the number of hedge funds that have long US bonds as their number one call.
And although I understand this view, I am worried it is too consensus. It might work, but it seems like everything in the global economy would have to go really bad for it to be a big winner.
In the mean time, a simple economic bounce might surprise the market way more than most hedgies are expecting.
I don’t trust her
Bringing this back to Yellen, I know she has indicated a dovish pause, but I don’t trust her. It wouldn’t take much for the Fed to be right back in play. If that were to happen, the hedgies will all scramble to get long US dollars again. And if the economic upswing was sustainable, the yield curve would experience a massive bear steepening. Given this out of consensus view, it is currently cheap to buy options on either of these outcomes.
I am not saying this scenario is by any means certain. I just think it is way more probable than the market believes…
Recently there has been a ton of press about the increase in Chinese M&A. This snippet sums it up well:
Chinese companies pursuing firms based in the United States isn’t a new trend in the M&A space, but it looks to be a growing one,” wrote Birstingl in a note Tuesday. “ In the first three months of 2016, there were 17 transactions announced in which a Chinese acquirer purchased a US target. This marked the largest transaction count of this deal type in the first three months of a year on record.”
Additionally, Birstingl noted, the value of deals made just in the past 3 months already eclipses the total for all of 2015. So far $28.8 billion worth of deals has been announced in 2016, versus $5.7 billion total for last year.
But this next part of the article is where I have to disagree:
Birstingl concluded that due to China’s slowing economic growth, this trend will probably continue as Chinese firms look for more profitable possibilities outside the country’s borders.
The exponentially growing mergers and acquisitions trend is not because China’s slowing growth, but the result of an overpriced Chinese Yuan. If a currency is overvalued, then the most logical move is for companies to buy foreign assets. It is kind of shocking that this concept isn’t getting more play.
The trade weighted Chinese Yuan is still sitting at the highs.
Granted at least it has stopped rising, but given the crazy amount of capital leaving China, it is probably still too high.
Thanks for reading,