Market Reads too Much into Yellen's Prepared Remarks

Late yesterday, Yellen's prepared remarks for her Senate Banking Committee confirmation hearings were released and sent the dollar in a tailspin in thin activity.  The dollar has been gradually clawing back those losses.  At the same time, soft euro area data and weak UK retail sales helped extend the dollar's recovery in Europe.  While Japanese data (GDP and industrial production) were largely in line with expectations, news that Japanese investors were net buyers of foreign bonds, helped lift the dollar, albeit briefly, though the JPY100 level for the first time in two months.  

Yellen's prepared remarks were short and seemed to be largely an explanation of the current stance of monetary policy.   That she stuck to the so-called party line is hardly news worthy.  After all, what else could the Vice Chairman do?    Unemployment is too high while inflation is too low.  To explain the Fed's actions, Yellen used some of the same phraseology that has appeared in the Fed's statements.  As the Vice Chairman, she also had to be careful about not building up expectations for a change in policy, one way or the other, which in the current context means, not signaling taping next month.  

Today's hearing is Yellen's first public appearance in five months.  She is an integral part of what we have referred to as the Fed's Troika (alongside Bernanke and Dudley) as the central committee, if you will, who's guidance offers the real signal of monetary policy, in contrast to the cacophony of comments from other officials.    She has been reportedly an important driver of the evolution of the Fed's communication innovations.  There is no reason to expect her to try to distance herself from the central bank's actions.  At the same time, continuity of Fed policy also means the completion of QE, which we continue to think begins slowing at the end of Q1 14, by which time, we expect the economy to show more signs of strength and price pressure to bottom out. 

While many market participants are most interested in the monetary policy stance, don't forget the Federal Reserve also has regulatory powers.  It should not be surprising if a good part of the Q&A with the Senators is about regulatory policy, Dodd-Frank and the too-big-to-fail problem. 

The biggest economic surprise today has been the unexpectedly large fall in UK Oct retail sales.  The 0.7% decline compares with the Bloomberg consensus  of a flat report.  The year-over-year rate slipped to 1.8% from a revised 2.0% in Sept (from 2.2%).  Poor weather probably exaggerated the decline, but real wages continue to be squeezed, as Carney noted yesterday and utility price hikes and rising transportation costs will further sap discretionary purchasing power.   Sterling held the $1.5985 area on the pullback, which corresponds to the minimal retracement objective of the rally in from the lows seen on Tuesday near $1.5850. 

The euro area economy expanded in Q3 for the second consecutive quarter, but the 0.1% pace was a bit lower than expected and slower than the 0.3% pace seen in Q2.  Of note, France stands out for disappointment.  The economy contracted 0.1% instead of expand by 0.1%.   The euro had risen to almost $1.35 to record the post-ECB high before reversing lower.    We peg support now near $1.3415 and then $1.3385.   That said, it probably requires a break of the $1.33 area to give confidence that a euro high is in place.  

The euro area finance ministers are meeting today and the focus is likely to be on the single resolution mechanism, though the Spanish and Irish program exits will also be reportedly discussed.  The single resolution mechanism remains controversial and exposes the fissure lines within EMU between creditor and debtor nations.  As is typically the case in Europe, some compromise formation is likely.   Part of the issue is also the role of the EU and the role of the finance ministers.   Germany is pushing hard for key decision to be reserved for the finance ministers.  

We do not attribute much significance to ECB's Praet comments yesterday, though the market initially used it as an excuse to take sell the euro off before buying it back.  Praet suggested that the ECB has numerous options, including a negative deposit rate and bond purchases.  This is true in theory and it makes sense for the ECB to play up it options.  However, it behooves investors to see through these theoretical points and focus on what is likely.  

These are the "nuclear" options in the sense that a negative deposit rate for a major central bank is unprecedented and can hurt the very banks the ECB is trying to assist.   A proper QE is "nuclear" in the sense that many regard it as outside the ECB's mandate.  Recall that two German ECB members resigned over Trichet's sovereign bond buying program.  The important point to keep in mind is that there are other measures shy of these "nuclear" options that the ECB is more likely to go to first.  These include another repo rate cut, a reduction in required reserves, some effort, perhaps through collateral rules, to do more to revive the ABS market.  

The dollar bloc currencies have also reversed their earlier Yellen-inspired gains.  The small decline in the consumer inflation expectations in Australia from 2.0% in Oct to 1.9% in Nov provided the ready excuse to reserve the Aussie gains seen yesterday and in early Asia.  It has retreated nearly a cent from the session highs, but finding a bid in front of $0.9280.  

For its part, New Zealand reported more mixed data, a stronger manufacturing PMI (55.7 from 54.2), but disappointing Q3 retail sales (0.3% vs consensus of 0.9% and a revised 1.5% in Q2 from 1.7% initially.  The Kiwi initially had rallied to almost $0.8360 after having frayed the neck line of a head and shoulders technical pattern (~$0.8200) yesterday.    The rally squeezed out many weak shorts who now appear to be chasing the market to re-establish.  As the North American session is about to begin, the New Zealand dollar is more than a cent off its session highs.  We still look for a convincing break of $0.8200.