The Fed Chairlady's Subtle Clues And How To Play This

by: Markos Kaminis


Today's Fed meeting carries with it the power to move markets.

Last week, Fed Chair Yellen addressed the market and offered some subtle clues about how the Fed perceives relevant matters.

Since Chair Yellen's appearance, several data points the Fed chair alluded to have been reported and offer signals as to Fed progression.

Other important events and changes have occurred since her appearance as well that will weigh on the Fed decision today.

I conclude with my expectations for the Fed and for financial markets.

When the Chairlady of the Federal Reserve last spoke to an attentive global audience from Philadelphia about a week ago, the focus was on her account and analysis of the surprisingly weak labor market data that had just been reported for May. Chair Yellen addressed the issue diplomatically, and seemed to believe like me that the May result will prove to be an aberration, especially given recent jobless claims indications. However, she also reminded us of the importance of the data point. Thus, May's Employment Report remains a haunting influence, and it seems the Fed would be wise to wait to see June's data before acting even despite other positive indications. Chair Yellen also addressed broader economic and international signals investors could look to in order to understand how the Fed perceives matters, and she hedged quite a bit. In conclusion, while June remains a live meeting, given the fear injected into financial markets since then by George Soros' impactful warning, by intensified Brexit risk, by the terrorist attack in Orlando, and by today's soft productivity data, not to mention the overwhelming expectations of the market for another pause in rate actions, a hike in June would seem highly unlikely. However, the Fed's economic projections and its press conference are very likely to direct market attention to July and still very active Fed monetary policy normalization (tightening) this year. Some upside is actually possible today on relief, but its duration will depend on the Fed's projections and the Chairlady's message at the press conference. There is a cap against upside and weight against the market until the U.K. referendum is concluded and as long as Brexit does not occur. Volatility is likely in both directions this week and next. Oil, stocks and gold should weaken if the dollar appreciates significantly on the Fed and ongoing Brexit concerns. Trades ahead of this event today are highly risky, and better clarity usually comes after the event has concluded, but not necessarily following the initial reaction. I will update followers as soon as possible. Long-term investors should have cash on the side to add new positions in coveted stocks at discounted values if they avail. Sophisticated investors may use volatility hedges to protect against the risk of Brexit.

When Chair Yellen addressed a group in Philadelphia a little over a week ago she shared an awful lot about how the Fed was thinking. It was more meaningful a speaking engagement than I expected it to be, and I noted some important and yet subtle clues provided by the Chairlady to look toward in the future. While the Fed continues to pursue full employment and healthy inflation, it's looking beneath the top-line data there for evidence of progress toward that pursuit. The reason for that is that the Fed realizes that it needs to precede economic normalization with monetary policy normalization in order to avoid overshooting, most importantly on inflation.

In this report, I highlight select quotes from Chair Yellen's address because her words are more important than mine, and because I believe the selected statements were most relevant.

Yellen: "If incoming data are consistent with labor market conditions strengthening and inflation making progress toward our 2 percent objective, as I expect, further gradual increases in the federal funds rate are likely to be appropriate and most conducive to meeting and maintaining those objectives."

The context of the statement is more important here than the statement itself, which is rather neutral in isolation. Recall that she made this statement just after the market received the depressing May jobs data. I found the words "incoming data" most interesting given that the market was focused on the weak jobs number and expecting the Fed to back off its normalization plans. After reading this, you should be aware that the Fed is looking to certain data and will weigh the data that has come in since the jobs data in making its decision for June. She basically left the door open because of the value of time between her speaking engagement and today's Fed decision, and because of the various opinions of Fed members which she cannot speak for ahead of time.

Yellen: "Although this recent labor market report was, on balance, concerning, let me emphasize that one should never attach too much significance to any single monthly report. Other timely indicators from the labor market have been more positive. For example, the number of people filing new claims for unemployment insurance--which can be a good early indicator of changes in labor market conditions--remains quite low, and the public's perceptions of the health of the labor market, as reported in various consumer surveys, remain positive. That said, the monthly labor market report is an important economic indicator, and so we will need to watch labor market developments carefully."

At the get-go, Chair Yellen plays down the importance of the monthly jobs report indication, and that should have been a clue for markets that June is still a live meeting. It is very true that the weekly jobless claims data have improved significantly in June, and indicate June's job creation data will be better than the weak number we saw in May. It was the weekly jobless claims weakness in May, along with some other clues, that helped me to forecast a sub-100K (predicted 84K) job creation estimate for May against a much higher consensus estimate. And it is partly because of the much stronger data for June that I worry a bit about today's decision.

Yellen: "As the downward pressure on prices from these two forces (oil prices & currency) dissipates and as the labor market strengthens further, I expect inflation to move back to 2 percent." Further down the speech she continues on energy's impact on the sector and regional economies," But the largest declines in drilling activity are likely now behind us, and with oil prices having recovered somewhat, I expect that oil prices will become less of a factor."

Chair Yellen notes here that two key factors that have worked against prices have been transitory in nature. Oil prices have recovered significantly over recent months and the dollar appears to Chair Yellen to be in the process of normalizing. Unfortunately, I have disagreed on both these issues this month, and have pointed toward a negative bias for oil prices near-term and dollar strengthening. Still, the Chairlady expects that over time (and I must agree on that time period) each will normalize and pressures against inflation will dissipate. But in the Fed's hopes to normalize and its goal to precede target inflation, might it act inappropriately?

Yellen: "I expect the economic expansion to continue, with the labor market improving further and GDP growing moderately."

I agree with the Chairlady on expectations for economic improvement and notably in Q2. I noted in her speech some common opinion, who came first (chicken or egg, me or the Fed) I leave for you to decide. I know that I stood fearlessly alone in February as markets panicked, and I called the bottom for stocks because of it (Buy Stocks - Why This Rally has Moxie on February 18 & It's Time to Buy Stocks on Feb 19). We each agree on economic recovery, but does that mean it's appropriate for the Fed to act now or not? We will try to work that out.

Yellen: "If the May labor report was an aberration or reflects a temporary slowdown resulting from the weakness in economic activity at the start of the year, then job growth should pick up and support further gains in income."

She makes points here that indicate she believes May's data was an aberration, if I may play psychologist. Chair Yellen even pointed to a potential lagged impact from Q1 upon the May jobs data, which is similar to what I said about that same report. The Fed is now also talking in terms of the negative feedback loop theory I floated in March about the early 2016 economic weakness.

Yellen: "Economic developments abroad have significantly restrained growth in the United States over the past year, although I am cautiously optimistic that these headwinds are now fading… net exports have been a drag on U.S. GDP growth over the past year and are likely to continue to weigh on growth over the medium term." Further down her speech she continues "So an important question is whether the U.S. economy could continue to make progress amid fairly considerable global bumpiness." She circles back around to international issues again further down the speech, "China faces considerable challenges as it continues to rebalance its economy toward domestic demand and consumption… One development that could shift investor sentiment is the upcoming referendum in the United Kingdom. A U.K. vote to exit the European Union could have significant economic repercussions."

The Chairlady points to some signs of improvement from China and Europe recently. But she seems to hedge herself by circling back to the very relevant concerns that remain for each region. Most notably in my opinion is the consideration of the U.K. referendum. Since her speech several polls have shown bets are increasing for Brexit. This trend has caught the attention of major investors and spurred a run to volatility. Before the VIX jumped, on June 3 rd, while stocks were still rallying toward their highs, you will recall my steady-handed recommendation to protect wealth and to consider using volatility instruments as hedges. The iPath S&P 500 VIX ETF (NYSE: VXX) has appreciated significantly since that suggestion, which is proving a valuable insight. Moving forward, the Fed has here its usable reasoning to pause again in June and reconsider in July, after the referendum and the June Employment Situation Report.

Yellen: "Business investment has been weak in the past six months or so, even beyond the energy sector, and investment in capital equipment is reported to have declined in the last quarter of 2015 and first quarter of this year… understanding whether, and by how much, productivity growth will pick up is a crucial part of the economic outlook."

The Chairlady cannot speak for her fellow Federal Open Market Committee (FOMC) members before they have met and decided on policy. Therefore, in this presentation a week ahead of the meeting, she seemed to hedge a lot and likely provide us with insight as to exactly what they will be talking about today. Notably here, she points to concern about business investment. However, just this week, Microsoft (NASDAQ: MSFT) acquired LinkedIn (NASDAQ: LNKD). Indeed, there is one sector, at the fringe of technology and innovation, where investment can never die.

She points to U.S. economic data signals all throughout her speech, specifically noting a need for productivity improvement and also reporting the improvement seen in job openings. From her comments we know the Fed will today have considered the recently reported improvements (since her speech) in job openings, growth in retail sales, increases in import & export prices, growth in business sales (strong sales kept business inventories hemmed), and greater small business optimism. However, this morning, new industrial production data showed a decrease of 0.4% for May alongside a decrease in capacity utilization. A smaller decrease of 0.1% was expected by economists, so the Fed has further reason to wait until June data for potential action in July.

Yellen: "I continue to believe that it will be appropriate to gradually reduce the degree of monetary policy accommodation, provided that labor market conditions strengthen further and inflation continues to make progress toward our 2 percent objective. Because monetary policy affects the economy with a lag, steps to withdraw this monetary accommodation ought to be initiated before the FOMC's goals are fully reached. And if the headwinds that have lingered since the crisis slowly abate as I anticipate, this would mean that the neutral rate of interest itself will move up, providing further impetus to gradually increase the federal funds rate."

Chair Yellen refers to the "neutral rate of interest" here, which I prefer to think of as the natural rate that might exist without a Fed. She indicates that it is currently low due to lingering headwinds. She says that as these headwinds abate, the neutral rate will move toward its mean and make it perhaps more comfortable for markets to accept increases in the Fed Funds Rate. I agree here, as there is much concern today about the yield curve and the risk of the Fed playing a part in its inversion. However, if Brexit does not happen, as I suspect, and if the economy grows as I expect, then the neutral rate will rise and Fed rate hikes can be digested by financial markets more easily.

Security Sector


Early Indication



SPDR Dow Jones (NYSE: DIA)


PowerShares QQQ (NASDAQ: QQQ)


iShares Russell 2000 (NYSE: IWM)


Vanguard Total Stock Market (NYSE: VTI)


Financial Select Sector SPDR (NYSE: XLF)


Technology Select Sector SPDR (NASDAQ: XLK)


Energy Select Sector SPDR (NYSE: XLE)


Health Care Select Sector SPDR (NYSE: XLV)


Consumer Discretionary Select Sector SPDR (NYSE: XLY)


Consumer Staples Select Sector SPDR (NYSE: XLP)


Utilities Select Sector SPDR (NYSE: XLU)


Materials Select Sector SPDR (NYSE: XLB)


Industrial Select Sector SPDR (NYSE: XLI)


iPath S&P 500 VIX ST Futures


SPDR Gold Trust (NYSE: GLD)


United States Oil (NYSE: USO)


PowerShares DB US Dollar Bullish (NYSE: UUP)


Yellen: "Over the past few months, financial conditions have recovered significantly and many of the risks from abroad have diminished, although some risks remain. In addition, consumer spending appears to have rebounded, providing some reassurance that overall growth has indeed picked up as expected. Unfortunately, as I noted earlier, new questions about the economic outlook have been raised by the recent labor market data. Is the markedly reduced pace of hiring in April and May a harbinger of a persistent slowdown in the broader economy? Or will monthly payroll gains move up toward the solid pace they maintained earlier this year and in 2015? Does the latest reading on the unemployment rate indicate that we are essentially back to full employment, or does relatively subdued wage growth signal that more slack remains? My colleagues and I will be wrestling with these and other related questions going forward."

Yellen: "I have explained why I expect the U.S. economy will continue to improve and why I expect that further gradual increases in the federal funds rate will probably be appropriate to best promote the FOMC's goals of maximum employment and price stability. I have also laid out the considerable and unavoidable uncertainties that apply to both this outlook for the economy and to the appropriate path of the federal funds rate. My colleagues and I will make our policy decisions based on what incoming information implies for the economic outlook and the risks to that outlook. What is certain is that monetary policy is not on a preset course, and that the Committee will respond to new data and reassess risks so as to best achieve our goals."

The Chairlady reminds us that despite the last FOMC meeting minutes indication, the Fed could wait a bit longer because of recent relevant data and events. However, it is also clear that July is a very live meeting, and Fed Funds Rate futures do not currently indicate that prospect. Market reassessments of such matters tend to lead to significant changes in asset prices. I anticipate the Fed will pause today, though its economic projections should still indicate a likelihood of at least two rate hikes this year. Markets may recover some ground on the simple passage of the event, enjoying some relief, but with the U.K. referendum and the prospect of Fed action in July still live, there is a cap to upside. And there remains significant risk to the downside as the market eventually contemplates a Fed action just a month away, given it is still unsure about the economy and the world. As or if that picture improves, stocks can rise on tangible reasoning. In the near-term, the dollar should appreciate and oil, stocks and gold should find pressure. So, in conclusion, expect volatility in both directions, with possibly some relief near-term depending on Fed projections and tone, and a weight against the market generally until Brexit no longer overhangs. I cover the market closely and invite those interested in regular analysis and insight to follow my column here at Seeking Alpha.

Disclosure: I am/we are long UUP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.