By Dean Popplewell
Expect Fed Chair Yellen to be walking a fine line later this morning. Ms. Yellen is due to testify on the Semiannual Monetary Policy Report before the House Financial Services Committee.
Her remarks will be closely monitored, especially in light of the recent increase in global economic insecurity, as investors seek some color on her thinking on the recent market volatility. The current market environment would suggest that dealers, traders and speculators alike remain wary of central bank’s ability to create growth and inflation.
The Fed chair will need to convince markets that the U.S. economy is improving, without alarming them about rate hikes. Skepticism about central banks is one reason for risk aversion causing sharp stock falls and strong JPY, CHF and EUR gains. The recent strength of theses funding currencies will be most worrying to their respective central banks (ECB, SNB and BoJ).
For months, currency markets had been holding on to the view that the Fed will raise rates repeatedly this year. However, it would seem that those expectations have changed dramatically over the past few weeks as weaker U.S. data, coupled with some dovish Fed rhetoric has Fed fund futures only pricing in a 30% chance of one U.S. rate hike in the next 11-months.
For many, there are a number of questions, none of them basic, that the Fed chairwoman should be asked to better understand the current economic dynamics that would/should be shaping Fed policy.
1. How is international weakness influencing U.S. economic prospects?
Recent U.S. data has been blowing somewhat “hot and cold.” Last week's non-farm payroll (NFP) report was good, but not stellar. Many will want to know more about Yellen’s forward-looking viewpoint on the U.S’s economy’s economic resilience. To date, the domestic consumer has been front and center of the U.S. recovery, what about the international variables and the strong dollar? The U.S. yield curve is very much at odds with the Fed’s “dot plot” thinking. Yields are plummeting (U.S. 10-years at 12-month low yields +1.72%) as investors seek safe haven assets and price out rate normalization occurring stateside. Everyone seeks assurances. Capital markets needs its hand held, but will Janet be able to provide a convincing delivery?
2. Wage growth remains an enigma not just for the Fed, but also for other Tier 1 central banks.
The Fed has a twin mandate, price stability and “max” employment. With the U.S. unemployment rate falling to +4.9% full employment is in the cross hairs. But, is the recent acceleration in wage growth in January’s NFP report sustainable? Both hourly earnings and hours worked crept higher and have led to predictions of more robust wage growth ahead. However, headlines may be deceiving as the details indicate that a number of U.S. states increased their minimum wage (effective January 1), and that the dispersal of wage growth was distributed towards higher income earners. Investors will want to know if this new cycle of wage growth is sustainable.
3. Central Banks are dealing with ‘low’ inflation and in some instances the fear of deflation. What’s the U.S. currently more fearful of?
An uptick in U.S. wage growth would suggest that the Fed should be policing for inflation. But, is inflation or deflation the main risk to the U.S. economy? It’s difficult to tell, however, there are a number of reasons why Yellen and company should be concerned about the possibility of deflation. Plummeting energy prices continues to lend its weight to the deflationary trend in Europe. Some central banks rely on policies that export deflation (i.e. currency devaluation). The market will want to know what Yellen’s view is on this, especially now that a “strong” dollar is getting more political airtime.
4. Deja vu: How strong is the U.S. and global banking system?
Financial stocks have been taking a global beating as the market relentlessly recalibrates their values. Bank share prices have plummeted mostly on concerns about potential ‘bad’ loan exposure to the energy sector and low net interest margins. Investors want to know if we are witnessing a system wide concern or is it just a new ‘real’ valuation?
5. Effectiveness of Central Bank unconventional policies
Capital market volatility would suggest that market participants continue to question the dynamics of Tier 1 central bank policies is having on global growth.
U.S. growth has been driven mostly by domestic consumer demand on the back of some unconventional Fed policies. On the whole, the Fed has been doing a good job, but what about the ECB, BoJ and PBoC? To date, they have not been able to suppress market volatility because investors do not seem to have much faith in their current policies.
Can central bankers be trusted to prevent any spillover into the broader economy? The market wants to hear Yellen’s assessment of the current risk; they want to know the potential frequency and timing of future interest rate actions. But, will Yellen be that open? We will know within a few hours.