The Day After: Yellen’s Big Mistake

So here we are, the day after a Fed hike that was supposed to (and by a lot of accounts needed to be) dovish.

Wednesday’s lackluster CPI and retail sales data should have been a “game changer” for Yellen’s messaging, a lot of folks contended, going into 2 p.m. EST. Simply put: by the time the Yellen presser rolled around, it seemed like the financial universe had planted themselves squarely on the “listen to inflation” side of the argument (the other side of that being “listen to the ostensibly overheating labor market”).

Instead, her comments were perceived as hawkish (in line with what at least one observer believes is the norm for the “diminutive woman with a pixie haircut”).

That triggered a rebound in the dollar (which had plunged earlier in the session on the CPI print), but probably the best way to visualize the whole thing is simply to look at the curve. At this point the 2s10s has collapsed below 80bps:

On person who is predictably irritated with this is former FX trader Mark Cudmore who on Wednesday morning predicted that you were going to be sorry for putting a gun to Yellen’s head and forcing her to hike.

Cudmore, like us and many others, thinks the Fed’s inflation targeting mandate might be antiquated, but importantly, he thinks that as long as they’re sticking to it, they have to be allowed to act as such. In other words: the market shouldn’t pigeon hole them into hiking when the deflationary impulse is building. This morning, Cudmore is out reiterating that. Here’s are the bullets from his latest note:

It may seem counter-intuitive but the Fed’s optimistic perspective on the U.S. economy makes it more likely that 10-year Treasury yields have more downside.
The problem for Janet Yellen is that the data is there for us all to see: What few inflation pressures did exist are now receding rapidly. By failing to comprehensively address the fact that the committee’s projections are constantly over-optimistic, they further undermine their own credibility
The Fed hasn’t been correct for seven years. The evidence would suggest their models are broken. Yellen still cites the Phillips curve even though some of her own committee have questioned its validity and it has shown no sign of working as anticipated in recent years
Temporary factors are cited as the reason for low inflation -— for example a decline in mobile phone bills — without acknowledging that the technological innovation frequently behind such factors isn’t a temporary phenomenon
Technology is also helping drive down external inflationary pressures coming through from commodity prices. And the committee’s models don’t seem to adequately account for demographic disinflationary impulses either
If Yellen had acknowledged that the policy frameworks she and her colleagues have been using since the crisis have all been incorrect, then we might believe she has a chance of now applying a more appropriate framework and has a credible plan to sustainably hit the inflation target
Instead, traders can’t help but feel that no lessons are being learned and will have to raise the probability of a major policy mistake in market pricing. This means that the yield curve will need to flatten further through long-end yields dropping

He’s not wrong.

Overnight, the dollar traded sideways after recouping its CPI/retail sales losses during the Yellen presser, but moved higher after Europe opened on pound and euro weakness:

Here’s SocGen’s Kit Juckes with his take:

The FOMC raised rates by 25bp, maintained a projection that suggests a further rate hike this year, while the infamous dot-plot looks for a 2.9% Funds rate a the end of 2019, and a 3% rate ‘in the long-term. Inflation forecasts for 2017 were cut and GDP forecasts were nudged up. Recent soft inflation was described as being transitory and more detail emerged of the plan to run down the Fed’s balance sheet. The short version of that is that they may start this autumn, and they will move slowly — so slowly that the balance sheet will surely still be huge when the next recession comes along.

Cue a debate about whether this was a hawkish move, given the absence of inflation. Surely we would have been extremely critical if they had left rates on hold when it was Fed communication more than anything else that persuaded the markets to price a move in with so much confidence. The Fed only wants to move when doing so is discounted by markets, so they have delivered this one despite the soft CPI print. But crucially, the tone of the discussion in the press conference about neutral rates still reflects huge uncertainty and concern about how low they are. The median long-term dot in the Fed Funds dot-plot may be at 3% but Janet Yellen doesn’t sound as confident of when ‘neutral’ is as is about the probability of hitting the inflation target.

All of this leaves rates trundling slowly higher and bond yields firmly in a range. 10year TIPS yields are at 42bp this morning, 1bp below their 2017 average, just below the mid-point o their 30-60bp range. That level makes USD/JPY look a bit low to me and as markets calm down, the yen should weaken again. EUR/JPY remains a very attractive buy here. But the big market driver may be less where TIPS go (nowhere) than where yields go elsewhere. Real 10year Bund yields are at -93bp, well above 2017 average levels. And low enough they have plenty of upside, which should underpin the Euro. For now, EUR/USD seems to have a hard ceiling at 1.13, but if we see positions lighten up somewhat while meandering in the current mini-range (1.1150-1.13?) then we will make a base from which to push higher.

Meanwhile, oil’s a horror show as WTI holds below $45 after gasoline inventories rose for a second week and the crude stock draw disappointed.

“The crude decline was less than expected and product stocks built,” Giovanni Staunovo, commodity analyst at UBS said overnight, adding that “refinery runs are so high that it’s difficult to see gasoline builds slowing down massively [and] the question is what the next driver is and it remains very focused on inventory data.”

Gold’s near a three-week low after giving back fleeting gains following the dismal data in the US Wednesday morning. “Given the intensity of the sell-off this week, we feel the market will take pause around this level,” Alex Thorndike, a precious metals dealer at refiner MKS, told Bloomberg by email.

Global markets were mostly lower as traders digested the Fed. Here’s a snapshot:

Nikkei down 0.3% to 19,831.82
Topix down 0.2% to 1,588.09
Hang Seng Index down 1.2% to 25,565.34
Shanghai Composite up 0.06% to 3,132.49
Sensex down 0.2% to 31,084.67
Australia S&P/ASX 200 down 1.2% to 5,763.19
Kospi down 0.5% to 2,361.65
FTSE 7412.53 -61.87 -0.83%
DAX 12672.56 -133.39 -1.04%
CAC 5180.82 -62.47 -1.19%
IBEX 35 10615.60 -160.20 -1.49%

Finally, here are the highlights from the SNB and BoE for anyone who’s inclined to care about that:

BOE

BOE Keeps Rate at 0.25%; Vote 5-3; Warns on Inflation Overshoot
Bank of England says Michael Saunders, Ian McCafferty joined Kristin Forbes in voting for rate increase.
BOE notes pound decline since May IR, says CPI overshoot may be bigger than previously thought
BOE notes firming global economy, investment, resilient consumer confidence
Hawks on MPC say that labor-market slack appeared to have diminishedDoves note consumer slowdown, say unclear how persistent it could be

SNB

Swiss National Bank keeps deposit rate unchanged at -0.75%, as predicted, and says it will remain active in foreign-exchange markets as needed.
SNB leaves 3-month Libor target range at -0.25% to -1.25%
Swiss National Bank sees 2017 GDP growth of about 1.5%, unchanged from previous forecast.
SNB sees 2017 CPI at 0.3%; 2018 at 0.3%; 2019 at 1%
NOTE: previously saw 2017 CPI at 0.3%; 2018 at 0.4%; 2019 at 1.1%
Says CHF remains significantly overvalued
To take the overall currency situation into account