Investors Size Up Yellen Collar as Dudley Outlines Fed Thinking

Ever since Alan Greenspan kept cash flowing through the financial system after the 1987 stock-market crash, investors have been able to count on Federal Reserve bailouts when things went awry.

They’re now being warned about a ceiling on potential gains by one of the U.S. central bank’s most reliable forward indicators: New York Fed President William Dudley.

As Fed Chair Janet Yellen and colleagues prepare to raise interest rates for the first time since 2006, Dudley used two appearances this week to signal the pace of the increases will depend a lot on how markets react to the initial moves.

“If financial-market conditions do not tighten much in response to higher short-term interest rates, we might have to move more quickly,” Dudley said on Monday. “In contrast, if financial conditions tighten unduly, then this will likely cause us to go much more slowly or even to pause for a while.”

Such a view, which he reiterated on Wednesday, suggests that when it comes to restricting monetary policy, the Fed will be concerned if stocks and bonds rise too far as much as if they hit the skids, according to Hans Mikkelsen, head of U.S. investment-grade credit strategy at Bank of America Corp.

That’s a change from when the central bank last began lifting its benchmark in 2004. Back then, financial conditions loosened even as Greenspan acted. Dudley said in December that hindsight -- recalling the 2008 financial crisis -- suggests the Fed should have tightened more or used regulatory tools to cool an overheating housing market.

Greenspan ‘Put’

Moreover, investors’ assumption then was that the Fed would bail them out if markets did take a dive, just as a “put option” protects against a fall in stocks; that gave birth to the expression “the Greenspan put.” Such talk was alive as recently as 2013 when Fed officials rushed to calm markets spooked by the prospect stimulus would soon be reversed.

If Dudley represents the consensus Fed view, officials will be just as active if bond yields fail to increase and equities keep rallying once the Fed raises its benchmark from near zero, New York-based Mikkelsen told clients this week.

In any event, he may have coined a new trading catchphrase: the “Yellen collar” -- a reference to an options strategy that limits the upside of a trade as well as the downside.

“This is the part that’s different this time,” said Mikkelsen. “If financial markets perform too well the Fed will have to counteract by being more aggressive.”

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