IT'S FINALLY HAPPENING

2016-10-17 12pm EDT  |  #Yellen #Greenspan #bonds #inflation #Federal Reserve #gold #silver

Janet Yellen gave one of her most important speeches of her life Friday afternoon. I think it might even end up rivaling Greenspan’s December 5th, 1996 “irrational exuberance” speech.

Last Friday Yellen threw in the towel on the whole idea the economy will normalize anytime soon. After years of forecasting rising rates due to an elusive return to pre-crisis economic growth levels, Yellen finally admitted what the market had long figured out.

The WSJ’s Jon Hilsenrath summed it up best:

Yellen Cites Benefits to Running Economy Hot for Some Time

Federal Reserve Chairwoman Janet Yellen offered an argument for running the U.S. economy hot for a period to ensure moribund growth doesn’t become an entrenched feature of the business landscape.

That would mean letting unemployment fall lower and spurring faster growth to boost consumer spending and business investment.

This could encourage businesses to spend more on new equipment that would have lasting benefits for the economy and encourage future growth, she said. A fast-growing economy and low unemployment also could encourage individuals who have stopped looking for work to start looking again, expanding the labor force and national income.

Moreover, running the economy hot could encourage higher levels of research and development and increase incentives for new business formation.

Still, her speech at a conference held by the Federal Reserve Bank of Boston offered a window into her mind-set and how policy might evolve in the months ahead. She effectively expressed sympathy for the idea of keeping short-term interest rates low to let the economy gather steam and reverse some of the long-run debilitating effects of the slow recovery, such as low labor-force participation and business investment. That implied very gradual rate increases in the months ahead.

Economic theory holds that weak demand can become a self-perpetuating problem for an economy. When businesses don’t invest and consumers don’t spend, it drives down the productive capacity of the economy and the pool of available labor, begetting still-slower growth. The idea is called hysteresis in economic circles. Weak demand begets weak supply, something Ms. Yellen saidwith some careful hedgesmight be reversed if demand is boosted.

“If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a high-pressure economy,’ with robust aggregate demand and a tight labor market,” Ms. Yellen. “One can certainly identify plausible ways in which this might occur.”

A hot economy would boost sales, which in turn would prompt managers to invest more in their businesses, she said. “In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines.”

This speech marks an epic change in attitude from Yellen. Although many Fed critics hold the belief Yellen is the most dovish Federal Reserve Chairperson in history, the facts don’t match their rhetoric. I have long argued that during her tenure, Yellen has tapered, stopped the QE programs and raised rates. In doing so, she has presided over one of the greatest (and most dangerous) US dollar bull markets in history. Here is a chart from my piece earlier this year, “There is no Mr. Wolf for the global financial system” that highlights Yellen’s performance as Fed chairperson:

Although there is no doubt Yellen is far from the Volcker type figure most hard money advocates want, she has not been nearly as dovish as widely claimed.

Until now…

This latest speech marks a complete shift in attitude. She has finally accepted the secular stagnation argument and has taken a page out of Paul McCulley’s argument that to break out of the vicious disinflationary circle, a Central Bank needs to be “responsibly irresponsible.”

I know some of you are already filled with rage wondering how encouraging more irresponsible monetary policy will fix the problem of too much irresponsible monetary policy. Yeah I get it, but all I can do is wish you luck arguing with the market. I am more interested in what will happen than what should happen.

Over the past year I have argued an overly tight US monetary policy caused the long end of the bond market to rally. I know it is not nearly this simple, but sometimes it is helpful to step back and look at the big picture. Assuming sovereign default is taken off the table, what is a bond investor’s worst fear? Inflation. And what creates inflation? A Central Bank that has monetary policy set too loose. Therefore when the long end of the bond market was rallying, it was because the Federal Reserve was too tight. There are obviously many more moving parts, but combine a rising US dollar with falling long term yields, and it is clear to me that over the past couple of years, Yellen & Co. were too aggressive in their attempts to normalize policy.

I am in the minority with this line of reasoning. Most market pundits believe the Fed’s failure to raise rates caused the long end of the bond market to rally (as opposed to my view that the Fed was tightening too quickly - see ‘Stan the Man’). Although I can understand why they might feel this way, if an investor believes a Central Bank to be easing too aggressively, it should actually cause the exact opposite behaviour.

Have a look at US 10 year yields during the period of Quantitative Easing:

Contrary to common wisdom, QE programs caused long term yields to rise. And yields fell once the QE programs were terminated.

So it was no surprise to me that after Yellen’s extremely dovish speech on Friday, 30 year yields exploded higher, while short term yields fell or held steady.

If Yellen leaves rates “lower for longer,” this means that there is an increased chance of inflation getting away, and long bonds are therefore significantly less attractive.

I have long waited for the Federal Reserve to realize their hawkish rhetoric is one of the greatest impediments to creating a self reinforcing virtuous loop. The world economy is balance sheet constrained. With a Federal Reserve itching to raise rates at every minor economic uptick, the private and public sector have had little concern about inflation taking off, so they have had no incentive to do anything except repair over indebted balance sheets. Instead of credit being created, it is destroyed as everyone tries to pay back debt at the same time. Given an overly eager Federal Reserve, market participants realize inflation will not take off, and therefore do the opposite of what the Fed wants. Instead of expanding credit, the velocity of money continually declines as there is no incentive to borrow. Economic participants realize that with the Fed leaning on the brake, there is zero chance inflation will hurt them. The huge level of indebtedness has changed the way the economy behaves.

If you accept the only way out of this debt mire is for it to be inflated away in the tried and true method of many millenniums, then it is imperative that the world’s reserve currency Central Bank changes its behaviour. And this is why Janet Yellen’s speech was so important.

Friday’s speech marks an acceptance of this realization. Uber doves like Larry Summers have long held this view, but until now, the Federal Reserve refused to climb aboard. The Fed has been strangely obsessed with normalizing rates.

Now some of you will cry out that this change in policy is a terrible development. It will cause inflation! It will debase the value of the US dollar! To this I answer; of course it will! That’s the whole point.

There is too much debt in the world and the only way out of this mess is for it to be inflated away. And even if you think there is an alternative solution, it doesn’t really matter as inflation is the most politically acceptable way to accomplish the needed debt reset. There is no real point in complaining about it. Better to just accept it and model your trading account accordingly.

I don’t think the Federal Reserve will back away from their signaled December hike. They will lose too much credibility (which is already dangerously low). Instead I think they will raise in December and indicate they will be on hold for quite some time. Not only that, but I suspect they will once again change the goal posts for further tightening.

Given Yellen’s change in tone I am re-evaluating my belief the US dollar will rally into the December hike. I had also recently flipped back to bullish on the precious metals, but this new development is making me consider being even more aggressively long. Finally, although some will view “lower for longer” as bond friendly, I don’t subscribe to that notion. I accept that buying the front end while shorting the long end makes sense, but overall, Yellen has probably ushered in the next great bond bear market.

Yellen has finally become the dove all the hard money guys have feared, I am positioning accordingly.

Thanks for reading,
Kevin Muir
the MacroTourist