Markets Exaggerate Yellen's Dovishness

Bond yields and the dollar fell.  Emerging markets and equities performed well.  The main cause appears to be Yellen's testimony to the Senate.  

Yet this seems to be an exaggerated response.  Going over Yellen's prepared remarks and answers to questions from the Senators, our basis understanding has not changed:  The Federal Reserve's monetary policy and forward guidance continues to evolve and prepare investors, including those foreign sovereigns and companies that borrowed dollars, for an eventual rate hike.  

There were three sentences that drove home this point:   "If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis.  Before then, the Committee will change its forward guidance...the modification [changing Fed's pledge to be patient] should be understood as reflecting the Committee's judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting."

In this Yellen tells us the next steps for the Fed.  The progression has been from "considerable period" to "patient", and the next step monetary policy decisions are on a meeting-by-meeting basis. Yellen is helping to navigate investors (and Congress) to a more data-dependent and less date-dependent approach.  

Yellen said little about time, but the entire framing of the issue and explaining what the next change in forward guidance means is preparing the market.  This is very much in the tapering-as-test-case spirit.  Before you do something, frame the issue and tell market what it will mean.  It makes little sense to point to this if one did not intend to go down that path shortly.  

The major point here is that our assessment of about an 80% chance of a hike in June and 15% chance in September and 5% after September remains unchanged after Yellen's testimony, and contrary to the direction of prices.  There are two other points we want to make.  

First, those who argue most strenuously against a mid-year hike emphasize the low inflation readings. Yellen's comments suggest this may not be such a high hurdle.  She recognized that the decline in energy prices weighs on the headline rate and has some spillover to the core rate.  The Fed has said, and Yellen reiterated it today, that after some additional near-term weakness in inflation, it continues to expect it to move towards the 2% target over the medium term.  

Second, Yellen's reference to the target range for fed funds is important and does not appear to be fully appreciated by many investors.  In the post-crisis period the Fed is not targeting a level for Fed funds as it previously did, but a range.  Currently that ranges is 0-25 bp.  The first hike would bring the new range to 25-50 bp. Many people trying to interpolate the Fed funds futures contract do not appear to have incorporated this into their models.