Yellen pulls a dove out of the Fed's hat

As we noted yesterday, market volatility was expected to pick up as we moved through the week as the top-tier data releases and traders at their desks gradually ramped up. Today we’re getting our first look at that phenomenon, with Federal Reserve Chair Janet Yellen making some waves at her speech to the Economic Club of New York.

In typical Janet Yellen fashion, the chairwoman came off as exceedingly cautious on the outlook for the US economy [emphasis mine]:  

  • Inflation expectations may have drifted lower; concerned by low inflation readings
  • The decline in some inflation indicators has heightened the risk that stable price expectations could be wrong
  • Committee should ‘proceed cautiously’ in raising interest rates
  • Caution "especially warranted" given low interest rates
  • Current neutral real interest rate likely close to zero
  • Fed "would still have considerable scope" to ease policy even if rates return to zero
  • Fed used non-conventional monetary policy tools in prevoius recovery, would do so again
  • The impact of global turmoil on the US is likely low, kept down interest rate expectations
  • Further declines in oil prices could have "adverse" effects on the global economy
  • I couldn't have imagined 6-7 years ago we would still be employing similar policies
  • It would be certainly helpful to see fiscal policy play a larger role

If the comments about "non-conventional monetary policy tools" (read: another round of quantitative easing) and the potential for interest rates to return to zero didn’t tip you off, this is a very dovish statement. Though she is just one of many voting members of the FOMC, her views typically reflect the influential "core" of the Fed, so many traders are taking this as a sign that we may not see any further interest rate hikes in the US until 2017. Indeed, fed funds futures traders have revised down the implied probability of a June rate hike to just 28%, and "only" a 71% chance of another rate hike at all this year. In other words, the Fed’s interest rate projections suggest that the central bank is back to wearing its rose-colored glasses on the US economy, at least relative to the market’s expectations.

Market Impact

The market impact of the more-dovish-than-expected speech was sharp and immediate. The US dollar index fell by 0.6% in the immediate aftermath as traders pushed back their rate hike timelines, and this drop in the greenback helped just about every other major asset class. US equities have turned solidly higher after spending the morning in negative territory, the benchmark 10-year US treasury yield is now down 6 bps on the day (bonds are rising), and even gold and oil have caught a bid, though oil still remains in negative territory on the day.

Intraday traders should definitely make note of these moves, but the market’s focus will quickly shift toward the rest of this week’s data, including ADP employment tomorrow, a speech by BOE Governor Carney, Eurozone CPI figures and Chinese PMI figures on Thursday, and of course, the critical US Non-Farm Payrolls report on Friday.

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