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Communication Breakdown


Federal Reserve Chairwoman, Janet Yellen, managed to do something quite extraordinary when the Federal Open Market Committee (FOMC) met last Wednesday. She succeeded in turning one of the most anticipated policy moves in recent memory (a 25 basis point increase in the Federal Funds rate) into a gut-wrenching roller coaster of volatility that spiked interest rates across the globe, sent the U.S. Dollar (USD) on a rampage, and forced emerging market central banks to tighten domestic monetary policies and sell precious USD reserves to defend their currencies. If there was a contest to come up with a theme to the Chairwoman’s press conference, I would choose “Hysteresis to Hysteria in 10 Simple Words.”

The markets had assigned a near 100% probability of the Fed Funds rate increase, as well as another one-to-two hikes in the second half of 2017. When the statement came out, there was some initial shock as the Fed’s “dot plot” showed that a majority of FOMC voters envisioned raising the Funds rate more than two times in 2017. While this was a bit of a shock, the market has learned to discount the dot plot as it has been a relatively poor predictor of actual policy and the votes are anonymous. The plot does not say which dots represent the Chairwoman, Vice Chairman, or President of the New York Federal Reserve Bank (traditionally the three most influential voters on the committee). The FOMC statement itself was very consistent with the November statement. I would describe the tone as tempered optimism. In short, the statement was on message.

During the accompanying press conference, Chairwoman Yellen was asked about the dot plot about which she was quick to remind that the dots calling for more aggressive tightening were “some, but not all” of the member’s projections. When she was asked if the market seemed prepared for the current policy move, as well as near-term policy moves, the Chairwoman answered affirmatively. Upon hearing these two answers, the rate and currency markets, which were roiled a bit over the dot plot, began to calm. And then it happened.

I had anticipated that the Chairwoman would be asked a question about comments she made in a well-publicized speech in October. In that speech, which led publications such as the Wall Street Journal to print headlines like, “Yellen Cites Benefits to Running Economy Hot for Some Time,” and caused the longer end of the Treasury curve to sell off, it certainly sounded like the Chairwoman was willing to underwrite a certain amount of inflation risk to counteract a condition called “Hysteresis.” Hysteresis, in economic terms, refers to a condition where a disrupting economic event occurs and passes, but the damage from the event remains for a long period of time. Ms. Yellen said in her speech:

“Interest in the topic has increased in light of the persistent slowdown in economic growth seen in many developed economies since the crisis. Several recent studies present cross-country evidence indicating that severe and persistent recessions have historically had these sorts of long-term effects, even for downturns that appear to have resulted largely or entirely from a shock to aggregate demand. With regard to the U.S. experience, one study estimates that the level of potential output is now seven percent below what would have been expected based on its pre-crisis trajectory, and it argues that much of this supply-side damage is attributable to several developments that likely occurred as a result of the deep recession and slow recovery.”

And then in response to the condition of hysteresis, a diagnosis that the Chairwoman seemed to clearly be assigning to the U.S. economy, Ms. Yellen said this,

“If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur.”

And finally:

“In addition, if strong economic conditions can partially reverse supply-side damage after it has occurred, then policy-makers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand.”

Upon the delivery of this speech, headlines stating that Ms. Yellen saw the benefits of running a “high-pressure economy” came out in nearly every major business periodical that very same day. Moreover, the markets reacted to the speech, and Ms. Yellen made no effort at all to walk back her comments. Vice Chairman, Stanley Fischer, did voice that running a high-pressure economy for too long was dangerous, but it was definitely not a firm repudiation of the Chairwoman’s speech.

At the FOMC press conference Wednesday, as I anticipated, a reporter asked Ms. Yellen about her belief in allowing for a “high-pressure economy.” Ms. Yellen answered, I never said I favor running a high-pressure economy.” Normally, I’d say you could hear a pin drop in the aftermath of these 10 words, but the silence was replaced by the buzz of every trader on the planet selling treasuries, mortgage-backed securities, and every currency (that wasn’t the USD) as fast as they could. This isn’t the first time the Chairwoman has contradicted herself and unfortunately, she will probably do it again. There is a reason why, not so long ago, members of the Federal Reserve were sphinx-like in their public personas. Their words are significant, especially when they talk about important things like future monetary policy!

Post-FOMC, we have had a sharp global sell-off in bonds. As rates began to rise in the U.S., the multi-trillion dollar mortgage market began increasing in duration, forcing those who have to hedge the increase in duration to sell duration. I estimate that number to be about $30 billion 10-year Treasury equivalents. This is called a “convexity event” and is the sort of thing that feeds on itself. It happened after the election of Donald Trump, and it has happened again this week. The 10-year Treasury is now approximately 2.60% (up approximately 16 basis from Wednesday) and the five-year Treasury has pushed well through 2%, bearing the greatest brunt of the selling.

Perhaps even worse, as I have been writing about the last few weeks, emerging market economies and China have their monetary policies and currency stability tied to U.S. monetary policy. Therefore, when the FOMC tightened policy and fumbled the ensuing communication about it, the effect was to dramatically tighten emerging market financial conditions as well. The USD has soared. The Morgan Stanley Trade Weighted USD Index rose to the highest level since the Index began in 1993.

A great example of the fallout from the “Fed Fumble” occurred yesterday in Mexico. The Mexican Central Bank raised its policy rate a surprising 50 basis points (from 5.25% to 5.75%) to counteract inflationary pressures that have hit the nation since the U.S. presidential election and exacerbated by the Fed last Wednesday. The last thing the Mexican Central Bank probably wanted to do was raise rates 50 basis points on Thursday, but they did because of the corrosive inflation caused by the weakening Peso. Mexico imports much of their natural gas and gasoline from the U.S., paying for it in USD. The country also has lots of USD-denominated debt and is subject to relatively easy capital flight. Mexico had to protect its currency. This scenario will be repeated throughout the emerging market world as well, and to some extent in China. The risk markets seem blissfully unaware or unconcerned of this growing global problem. I’m not sure when they will become aware of it, but to a large degree, the fuse is lit and soon enough we will have awareness.

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