The Daily Prophet: The Janet Yellen Markets Once Knew Returns

Connecting the dots in global markets.

It felt like the good old days in markets Wednesday, when most everyone seemed like a winner thanks to a dovish-leaning Janet Yellen. The Federal Reserve chair delivered a minor surprise in her semi-annual testimony to Congress when she didn't just mindlessly repeat the Fed's mantra that the recent slowdown in inflation is due to temporary items such as lower prices for wireless telephone services and prescription drugs. Instead, she hinted that what's happening may be more than transitory.

Investors interpreted the comments as meaning a September interest-rate hike is in doubt as the rate of inflation falls further below the Fed's 2 percent target. The Dow Jones Industrial Averaged jumped more than 100 points, bonds of all stripes rallied and emerging-markets strengthened the most since March amid speculation the Fed is down shifting into "go slow" mode. That's not a foolish assumption, given how the Fed has often started out in recent years as sounding very hawkish before having to tone down the rhetoric as inflation data disappointed on the downside even with improvements in the labor market. For most markets, that's an ideal environment as long as the economy stays in the not too hot, not too cold zone.

"Yellen said nothing new today, but traders have chosen to interpret her standard boilerplate about no predetermined policy course and a symmetric 2 percent inflation target as hinting at a rate hike pause," FTN Chief Economist Chris Low wrote in note to clients. “Given the way the Fed has vacillated for years between certainty and doubt about its forecast, it is not an unreasonable conclusion."

Besides stocks, the most visible beneficiary of Yellen's remarks was the bond market. Yields on benchmark 10-year Treasuries fell the most in almost a month as bond prices jumped. The rally was a bit of a relief for a market that has been under siege in recent weeks. Besides the potential for a slower pace of rate hikes, bonds also benefit from a slower pace of inflation, which preserves the value of fixed payments over time. JPMorgan's weekly survey of fixed-income investors released Tuesday showed sentiment has fallen to its lowest of the year, to levels rarely seen since the financial crisis. July is isn't even half over and the Bloomberg Barclays Global Aggregate Index was already having its worst month since November, falling 0.65 percent through Tuesday. Traders are even more skeptical that the central bank will raise rates again in 2017, as policy makers signaled in their latest projections last month. The odds of a September hike, based on the implied rate of federal fund futures, fell to about 12 percent, while the probability of an increase by year-end dropped to around 50 percent, according to Bloomberg News' Alexandra Harris.

Another big winner was emerging-markets. The MSCI Emerging Markets Index of stocks and the MSCI EM Currency Index both jumped the most since mid-March. The thinking here is that a slower pace of Fed rate hikes will weigh on the dollar and preserve the relatively wide gap between U.S. and developing-nation bond yields, further boosting the appeal of emerging-market currencies. The weakening greenback combined with higher interest rates in developing nations has triggered record inflows to emerging-market funds in the first half of 2017. The MSCI index of stocks has already jumped 19.7 percent this year, compared with 11.4 percent for the MSCI All-Country World Index. Of the five biggest gainers against the dollar Wednesday, four were from emerging markets, led by the South African rand's 2.23 percent jump. The other big winners were Brazil's real, Turkey's lira and Russia's ruble.

It's been an unexpectedly tough 2017 for the dollar and Yellen's comments did nothing to help. The Bloomberg Dollar Spot Index fell again, bringing its year-to-date decline to 6.77 percent. If interest rates aren't heading higher, then there's less of an incentive for foreign investors to buy dollar-denominated assets. One would have to go back more than four years to find the last time investors were so down on the dollar. The latest Commodity Futures Trading Commission data, released late Friday, showed that hedge funds and other large speculators have amassed the biggest net short position against the greenback since February of 2013. Wagers that America's currency will weaken were outnumbered by bets it will strengthen by 81,582 contracts in the latest weekly reporting period, up from 30,037 contracts the previous week. In fact, that might the only thing the dollar has going for it -- so many investors are betting against it that any positive data could trigger a nasty short squeeze that sends the currency higher. Remember when President Donald Trump said in April that the dollar was getting too strong, and that was partially his fault because people had confidence in him? I wonder what'd he say -- or tweet -- now? 

It wasn't all about the Fed and Yellen. Canada cautiously became the first Group of Seven country to join the U.S. in raising interest rates on Wednesday. The Bank of Canada boosted its benchmark rate to 0.75 percent from 0.5 percent, while adding an element of prudence by warning future rate hikes would be “guided” by the data, according to Bloomberg News' Theophilos Argitis. Notwithstanding Yellen's remarks today, investors are looking at the decision as a possible harbinger of things to come globally and are monitoring it for clues on central banks’ resolve for withdrawing stimulus. Canadian government bond yields and the country’s currency rose after the hike, on expectations the Bank of Canada would follow with a second increase this year. Canada is in the midst of one of its strongest growth spurts since the 2008-2009 recession, with the expansion accelerating to an above-3 percent pace over the past four quarters. That’s the fastest among G-7 countries and double what the central bank considers Canada’s capacity to grow without fueling inflation.

The next few days may determine whether Yellen's perceived caution on inflation is warranted. On Thursday, the Labor Department will release its producer price index data for June. While the median estimate of economists is for no change, wholesale prices had been trending higher this year until April. Since then, oil prices have dropped, which could weigh on the index. On Friday, investors get the more important Consumer Price Index. The median there is for the index to show a 1.7 percent increase from a year earlier, down from the 1.9 percent jump in May.  

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Fed's Balance Sheet Unwind Comes at Inopportune Time: Scott Dorf

Why Commodity Traders Are Fleeing the Business: Shelley Goldberg

Smart Beta Looks Great in the Rearview Mirror: Barry Ritholtz

The Caution Light Blinking in Yellen's Testimony: Daniel Moss

The ECB Is Better Flexible Than Sorry: Ferdinando Giugliano

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